1A. Financial Statements P2
Unit 1. External Financial Reporting
Decisions
Statement of Cash Flows
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1A. Financial Statements P1
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Income Statement
Provide information about revenues,
expenses, gains and losses associated with
company operations during a period
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Investors: profitability and value
Lenders: creditworthiness
Managers: useful decision making
Provides information on sources and
uses of cash and cash equivalents
Assesses liquidity and solvency
Classification of activities
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Operating:
income
statement,
current operating assets, current
operating liabilities
Investing: purchases and sales of
non-current assets
Financing: cash inflows and outflows
from noncurrent liability (creditors)
and equity (owners)
Significant Noncash Investing and
Financing: material transactions not
involving
cash
receipts
or
disbursements
Limitations
Limitations
Cash basis does not match accrual basis
recognition of revenues and expenses
Manipulation through assumptions and
estimates, not true representation
Management decisions may not be fully
reflected:
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Depreciation: method, modify useful
life, salvage value
Bad debts: evaluation of receivables
risk
Warranties: likelihood and amount of
future claims
Income Smoothing
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Benefit: better able to project future
performance
Detriment: disguises risk, alters true
picture of performance
Putting
operating
nonoperating
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expense
in
Issuing debt reflected as cash inflow
does not represent future cost
Buying equipment reflected as cash
outflow does not represent future
benefit
Cash flows from Operating Activities
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Classification Shifting
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Direct method: If elected the
company still must present indirect
method, there is no reconciliation
from the income statement
Indirect method: Start directly from
net income
Cash flows from Financing Activities
Indirect method connects very explicitly to
accrual basis financial statements
Add back noncash expenses (depreciation
and amortization) and +/- gains/losses in
investments: expenses that affect NI but
have no cash impact
Changes in Current Assets and Current
Liabilities
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Decreases in CA and Increases in CL:
either
collecting
money
(A/R
decreases
receives
cash)
or
postponing paying money
Decreases in CL and Increases in CA:
Putting off collecting money or
paying off money owed
Typically, a healthy company has a positive
Operating Cash Flow (OCF)
Cash flows from Investing Activities
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Trading securities are current assets,
but long-term TS are non-current
Net change in Cash
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Total all operating, investing, and
financing cash flow
Reconcile total change in cash and
cash equivalents
Include material noncash investing
and financing
Summary
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1A. Receivables
Accounts Receivables
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Oral promise to pay debts; represents
future cash receipt
Generally current assets: do not want
to wait for more than a year to receive
payment
on
an
outstanding
receivable
Types of Accounts Receivables
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Trade: from purchasers of company’s
good and services
Nontrade: from any other persons
Reported at Net Realizable Value: factors in
uncollectible accounts (customer is unable
to pay), sales discounts (purchases in bulk),
and sales returns (sending back purchases)
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Trade discount
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Recorded at net, quantity-based price
reduction
E.g: If x purchases then 5% off, so
only 95% will be recorded
Uncollectible Accounts
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*How much we are going to collect
Changes in AR in an accounting period
Discount: 2/10, n/30 -> 2% paid
within 10 days, net amount due
within 30 days
Gross method: record receivables at
100%, discount recognized if/when
paid within discount period
Net method: record receivables at
98%, forfeited discount recognized
when paid after discount period
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GAAP requires use of allowance
method (based on total receivables,
what you believe is not going to be
collected out of the grand total,
creating an allowance)
Allowance is an estimate of current
expected credit loss (CECL)
CECL: factors current conditions, past
experience, future expectations of cash
collection over the life of each receivable
Basis of Allowance Computation
Percentage of accounts receivable
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Subsequent cash collections to be
received
Write-offs where it is decided we are
not going to get paid for money owed
Conversion to NR: spread out
payments typically in x years and AR
is moved to NR
Sales and Cash Discounts
Incentive for prompt payment
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Based on year-end receivables
balance
Adjusted using debits/credits to bad
debt expense and the allowance for
uncollectible accounts
E.g: with $100k year-end assume 1%
going to go bad, so there is an
allowance of $1k then adjust bad
debts to correct for the allowance
Aging of accounts receivable
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Accounts grouped into categories
based on relative age of each account
receivable
The older the receivable is the more
likely it is to go bad, more accurate
Percentage of each category is
combined to determine the total
allowance
Older receivables are less likely to be
collected;
therefore,
larger
uncollectible percentages are used
Bad debts expense
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At the end of the day, how much are
we giving back to bad debts?
Provision calculated during the year,
+/- year-end adjustment
Sale of accounts receivable, conversion of
receivables into cash by selling them to a
factor either with or without recourse
Factor: the person we are selling to
Without recourse (sale)
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With recourse (loan)
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Journal entries for AR adjustments
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Write-off: get rid off general
allowance since it cannot be collected
anymore, P&L/NI effect is 0 since it’s
written off
Reversal, same accounts but reverse
it then record normally
Increase in allowance account:
Bad debts expense (DR)
Allowance for uncollectible account
(CR)
Factoring of Accounts Receivable
Factor (buyer) assumes any risk of
loss on collections/no recourse
against seller
Recorded
as
true
sale
with
recognition
of
gain/loss
as
appropriate
Factor (buyer) has the option to sell
uncollectible receivables back to the
seller
Recorded as a loan with a recognition
of a liability for the potential recourse
of the factoring
Potential that there will be payment
to the factor to re-acquire receivable
at a future point
1A. Inventory
Inventory Systems
Inventories
Purpose: What type of system is used to
track the goods while it is in possession of
the company?
Wholesale/Retail
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Purchased
and
resold
merchandising companies
by
Manufacturing
Raw Materials
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Periodic Inventory System
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Held for use by manufacturing
companies in production
Quantity of inventory determined by
physical count
Cost of goods sold computed
indirectly
Work-in-Process (WIP)
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More than 0% but less than 100%
production completed
Includes raw materials, direct labor,
and manufacturing overhead
Finished Goods
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Production completed and ready for
sale
Goods and Costs to be included in Inventory
Goods-in-Transit: key consideration is when
the title passes from seller to buyer
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FOB shipping point: title passes to
buyer when transferred from seller to
common carrier
o ✅ Supplier SP – include
Cost of goods available for sale: If the
company could sell everything it has, how
much would it be? Logically, it’s what the
company currently has (beg) and the goods
it has purchased (purchases)
Ending inventory: There will be some
inventory not sold so it has to be deducted
from CoGAS, it will end up with the
inventory sold – COGS
When selling inventory journal entry:
Cash (DR)
o ❌ Customer SP – exclude
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FOB destination: title passes when
transferred from common carrier to
buyer
o ❌ Supplier D – exclude
Sales (CR)
When purchasing/buying inventory journal
entry:
Purchases (DR)
o ✅ Customer D – include
Nonconforming goods: title reverts upon
buyer’s rejection of goods
Consigned goods: consignor retains title
until consignee sells
Cash (DR)
Perpetual Inventory System
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Always current because it is
constantly, perpetually updated
Inventory quantity updated with each
purchase and sale
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Physical count used to check/adjust
inventory balance
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Represents most recently incurred
cost
Approximates replacement cost
Cash (DR) – selling price
Cost of goods sold and ending inventory
are the same whether using periodic or
perpetual
COGS (DR) – historical cost
Weighted Average
When selling inventory journal entry:
Inventory value based on weighted average
of all costs
Sales (CR) – selling price
Inventory (CR) – historical cost
When purchasing/buying inventory journal
entry:
Best suited to homogenous products
recorded using periodic inventory
Inventory (DR)
Cash (DR)
Perpetual system is constantly updating the
inventory
Inventory Cost Flow Assumptions
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Used for valuing the inventory
US GAAP does not require cost flow
assumption to mirror physical
inventory
Objective is that the method clearly
reflects the income earned
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Cost of each item is uniquely
identified and tracked
Typically used for physically large
and/or high-dollar items
o Car dealerships
Potential for manipulation if there are
two identical items with differing
costs
Ending inventory
Moving Average
Inventory value based on average cost per
unit recalculated after each purchase
Compared to weighted average, valuation is
more current
Requires use of perpetual inventory
Last In First out (LIFO)
Last cost inventoried
transferred to COSGS
->
first
cost
LIFO is prohibited under IFRS
First In First Out (FIFO)
First cost inventoried -> first
transferred to cost of goods sold
End Inv: Weighted avg cost per unit x units
not sold
Same as WA calculation but it’s different
averaged again after new purchases
Specific Identification Method
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COGS: Weighted avg cost per unit x units
sold
cost
Ending inventory
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Represents oldest costs
Not representative of replacement
cost
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Typically, not how companies sell
their inventory
Electing LIFO for tax purposes =
required use under US GAAP
Susceptible to manipulation by
adjusting purchases
General rule: at cost (applying inventory
cost flow assumptions)
When inventory value is less than cost,
depart from cost basis since you will not be
able to recover from the loss
Typical adjustments include to market or to
NRV
LIFO Layers
In periods of rising prices, if purchases
exceed sales LIFO layers are created
Matches old costs to currents sales,
distorting income, aka LIFO Liquidation
Dollar value LIFO
Recorded through COGS or separate line
item if material
Reversal of losses prohibited under US
GAAP but allowed in IFRS
Lower of Cost and NRV
By what degree
IFRS: all is fine and US GAAP: fine unless
using LIFO or retail
Inventory is measured in dollars and is
adjusted for changing price levels
Can be applied by item, by category or to
the inventory as a whole
When converting from LIFO to dollar value
LIFO, a price index will be used
NRV = Selling price (Completion cost)
(Disposal Cost)
In some problems, the price index will be
internally computed, others supplied
Lower of Cost or Market
US GAAP (LIFO or Retail only)
Can be applied by item, by category or to
the inventory as a whole
Market value = Replacement cost
Advantages and Disadvantages of Cost
Flow Assumptions
Valuation of Inventory
Market value subject to limits:
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Ceiling: NRV
Floor: NRV – Normal profit margin
Inventory Errors
Inventory Differences Between US GAAP and
IFRS
1A. Investments and Long-Term Assets
Reported at Amortized Cost
Investments in Debt Securities
No unrealized holding gains or losses are
recognized
Debt securities represent
relationship with an entity
Include
Corporate Bonds
Redeemable
preferred
stock
Government securities
Convertible debt
Commercial paper
a
creditor
Exclude
Options
Future
Impairment
Reported at Fair Value
Current expected credit loss (CECL) is based
on net amount expected to be collected
Trading
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Bought and held with intent to sell in
the near term
Generally recorded as current asset
Available for Sale (AFS)
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Neither trading nor HTM
Generally non-current,
based on intent
ultimately
Reported at Amortized Cost
Held-to-maturity
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Reclassification
Forwards
Leases
Accounts
receivable
Notes receivable
Classification
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No realized gains or losses from the sale of
HTM securities because they are held to
maturity
Positive intent to hold maturity
Ability to hold maturity
Current or non-current based on time
to maturity
Valuation
Reported at Fair Value
Unrealized holding gains/losses
Trading securities – recognized in net
income
AFS securities – recognized in OCI Realized
gains/losses result when the security is sold
Recognized as period expense
allowance against investment
and
For investments in debt securities, a credit
loss is recognized if it is determined that all
principal and interest will not be collected
HTM: should be reported at the present
value of the principal and interest to be
collected, difference between PV and
amortized cost is credit loss
AFS: credit losses are limited by the amount
that FV falls below amortized cost
Sale of Debt Securities
Trading
Difference between current book value and
selling price recognized as a realized
gain/loss
Available-for-sale
Difference between original cost and selling
price is recognized as realized gain/loss in
IS
Accumulated OCI for unrealized holding
gains/losses written off
1A. Liabilities and Equity
Liabilities
Stockholders’ Equity
Probable future sacrifices of economic
benefits arising from present obligations
Capital Stock
Trade Accounts Payable
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Owed
for
goods/raw
materials/supplies
Not evidenced by a promissory note
Current Portion of Long-Term Debt
Principal due within the next year is current
liability
When the debt is refinanced
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Debtor must intend to refinance
Debtor must have the ability to
refinance
Ability = actual refinancing prior to
financial statement issuance or
existence of noncancelable financing
agreement
Warranties
Promise to correct product defects or
compensate the buyer
Assurance Warranty
Legal capital: capital that must be retained
for protection of creditors, represented by
par/stated value
Authorized shares: Corporate charter will
provide the par value as well as the amount
of each class of stock that may be legally
issued
Issued shares: When shares/portion of it
are issued
Outstanding shares: shares in the hands of
shareholders not held as treasury stock by
the corporation
Classes of stock
Common
Basic ownership interest with right to vote
and management oversight
Not guaranteed dividends or assets upon
dissolution
Right to share in earnings and bear ultimate
risk of loss
Not a separate performance obligation so
no related revenue regulation
Preferred
Accrued warranty the liability and expense
recorded at time of sale to match revenue
and expenses
May have preferential rights for dividends
in liquidation
Service Warranty (Extended Warranty)
Separate performance
revenue recognition
obligation
and
Recognition of liability at time of sale
Warranty revenue recognized over time/as
earned
Typically does not have voting rights
Dividend rights may be
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Cumulative or noncumulative
Participating or nonparticipating
Additional Paid-in Capital
Generally represents capital contributions
in excess of par/stated value
Can arise from other transactions:
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Property: Distribution of noncash assets,
restate of FV with gain/loss recognized in
income
Sale of treasury stock at a gain
Liquidating dividends
Bond conversion
Small stock dividends
Treasury stock
Corporation’s own stock – issued ->
reacquired by the corporation -> not retired
Not entitled to vote, receive dividends, etc
Retained earnings may be restricted due to
treasury stock presence
Retained Earnings (Deficit)
Accumulated earnings (losses) during the
corporation’s life not paid out as dividends
Small stock dividend: less than 20-25% of
shares outstanding are distributed, not
expected to impact the market price of the
stock, transfers at market value from RE to
common stock and APIC
Large stock dividend: more than 20-25% of
shares
outstanding
are
distributed,
expected to impact the market price,
transfers at par value from RE to common
stock only
Stock Splits
Issues additional shares of its own stock
Reduces par value per share in proportion
to shares issued
Dividends
Pro rata distribution of earnings
Preferred stock: fixed dividend, set amount
as percentage of par value
Common stock: total dividend amount less
preferred dividends
Key dates
Date of declaration: board of directors’
approval
Date of record:
determined
date
ownership
Date of payment: date dividend is paid
Dividend Type
Cash: Distribution of cash
is
1A. Special Valuation Considerations: Taxes
and Leases
Accounting for Income Taxes
Intraperiod tax allocation
Matches tax provision to components of net
income and retained earnings
Interperiod tax allocation
Results from differences between the IRS
Tax Code-based return ang GAAP-based
financial statements
Current year taxes
Payable (liability) or refundable (asset)
Future year taxes
Deferred tax asset or liability
Accounting for Interperiod Tax Allocation
Total tax expense (benefit)
Total of current tax expense (benefit) and
deferred tax expense (benefit)
Current income tax expense (benefit)
Amount payable (refundable) based on the
current year per the corporate income tax
return (Form 1120)
Affects either book income or taxable
income but not bothDoes not reverse -> no
deferred tax -> no interperiod tax allocation
Examples include:
Tax-exempt interest (municipal, state)
Life insurance proceeds on officer’s key
man policy
Life insurance premiums when corporation
is beneficiary
Certain penalties, fines, bribes, kickbacks,
etc.
Nondeductible portion
entertainment expense
Dividends-received
corporations
of
meal
deduction
and
for
Excess percentage depletion over cost
depletion
Temporary differences
Four basic causes of temporary differences,
which reverse in future periods
Can also result from differences in book
and tax basis of assets and liabilities,
liabilities stemming from an acquisition, or
certain foreign currency transactions
Deferred income tax expense (benefit)
Change in deferred tax liability or deferred
tax asset during the period (balance sheet
approach)
Permanent Differences
Deferred Tax Assets/Liabilities
Liability
Lessee Account for Operating Lease
Future taxable income will be greater than
future financial accounting income
Balance sheet
Asset
Anticipated that future taxable income will
be less than future financial accounting
income
If more likely than not that some or all of
the asset will not be realized, a valuation
allowance must be recognized against the
asset value
Right-of-use (ROU) asset and lease liability
Amortized using the effective interest
method over the life of the lease
Value based on PV of lease payments at an
appropriate discount rate
Income statement
Lease expense
expense)
(inclusive
of
interest
Accounting for Leases
ROU Asset and Liability Calculations
Lessor
Inputs into the calculation of the ROU asset
and lease liability must be properly
evaluated and calculated
Conveys the right to control the use of
real/personal property
Lessee
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Agrees to pay consideration for this
right over a period
Contract must depend on an
identifiable asset where lessor does
not have a substantive right of
substitution
Right to control the asset must be
conveyed to the lessee
Lease term: Noncancellable period for
which a lessee has the right to use
Lease payments: Fixed payments, variable
payments based on an index rate, exercise
price or penalties associated with options
that are reasonably certain to be exercised,
or any amounts profitable under a residual
value guarantee
Discount rate: Rate implicit in the lease; if
that rate is not readily determinable, the
lessee must use its incremental borrowing
rate
Lessee Accounting for Finance Lease
Balance sheet
Right-of-use (ROU) asset and lease liability
Asset includes the amount of the lease
liability initial direct costs connected to
lease execution, any lease payments made
by lessee, and lease incentives received
Liability represents the present value of
lease payments owed over the lease term
Income statement
Interest expense recognized based on
amortization of lease liability
ROU asset amortized on a straight-line
basis, unless another systematic basis is
more representative of the pattern in which
the lessee expects to consume the future
economic benefits of the asset
Balance Sheet Presentation
May be recognized as a separate asset and
liability or may be recognized with other
assets and liabilities with specific amounts
disclosed in the footnotes
Portion of lease liability due within one year
(or operating cycle if longer) is presented as
current liability
Lease liability – reduced as principal paid
down
Income
and
Presentation
Cash
Flow
Statement
Income statement
Operating lease includes lease expense
Finance
lease
includes
ROU
amortization and interest expense
asset
Cash flow statement – Operating Lease
Generally classified as operating cash flow
Costs to prepare the asset for its intended
use classified as an investing cash flow
Cash flow statement – Finance Lease
Principal payments classified as financing
cash flows
Interest payments classified as operating
cash flow
Variable/short-term payments not in lease
liability classified as operating cash flow
Differences Between US GAAP and IFRS –
Lessee Accounting
1A. Revenue
Measurement
Recognition
and
Income
Revenue Recognition
Occurs when an entity satisfies a
performance obligation by transferring
either a good or service to a customer
Amount recognized is based on expected
consideration entity is entitled to receive for
the good or service
Unless a specific contract type is covered by
another standard, contracts with customers
to
transfer
goods,
services,
and
nonfinancial assets adhere to the revenue
recognition principles
Five-Step Approach
1. Identify the contract with the customer
2. Identify the separate
obligations in the contract
performance
3. Determine the transaction price
4. Allocate the transaction price to the
separate
performance
obligations
(identified in Step 2)
5. Recognize revenue when or as the entity
satisfies each performance obligation
Step 1: Identify the Contract(s) With the
Customer
Contract = Agreement involving two or
more parties that creates enforceable rights
and obligations
Five conditions must be met in order to be
considered a contract under the revenue
recognition standard:
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All parties have approved the
contract and are committed to
perform their obligations
Rights of each party are identified
Payment terms are identified
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Contract has commercial substance
Collection of all consideration is
probable
Step 2: Identify Separate Performance
Obligations
Performance obligation = Promise to
transfer a good or service to a customer
Performance obligation can be for an
individual good or service, a distinct bundle
of goods or services, or a series of goods or
services that are substantially the same
Step 3: Determine the Transaction Price
Consideration expected for transferring
goods or services to a customer
Variable Consideration: use either expected
value based on range of potential values or
most likely single amount
Significant Financing: if the timing of
payments provides a significant benefit to
either party, the time value of money
should be factored into the price
Noncash
Consideration:
measured at fair value
should
be
Consideration Payable to a Customer:
treated as a reduction in the price
Step 4: Allocate the Transaction Price to the
Separate Performance Obligations
If there is more than one performance
obligation in a contract, allocate the
transaction price to each separate
performance obligation based on the
consideration that would be expected to
satisfy each separate obligation.
Step 5: Recognize Revenue When/as Entity
Satisfies Performance Obligations
Satisfies over time if any one of the
following criteria is met:
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Performance creates/enhances an
asset
Customer
receives
benefits
of
performance as it is performed
Performance does not create an asset
with alternative use and the seller has
enforceable right to be paid for work
performed to date
Progress measured by output measures
(e.g., units produced, units delivered, time
elapsed, milestones achieved) or input
measures (e.g., costs incurred vs. total
expected costs, labor hours expended, time
elapsed)
Step 5: Recognize Revenue When/as Entity
Satisfies Performance Obligations
Otherwise, satisfies at a point in time when
the customer has asset control
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Entity has a right to payment and
customer has an obligation to pay
Customer has legal title to the asset
Entity has transferred physical
possession of the asset
The customer has the risks and
rewards of ownership
The customer has accepted the asset
1A. Consolidated Financial Statements
Introduction to Consolidations
Companies often invest in the debt and
equity securities of other companies as a
strategic move to:
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broaden their portfolios
explore new market opportunities
gain a competitive advantage; or
utilize surplus funds.
The extent of ownership a company obtains
in an investee depends on factors like
available resources and the desired level of
influence or control over the investee.
Lack of significant influence: Investor holds
less than 20% equity interest
Significant
influence:
Investor
holds
between 20% and 50% equity interest
Controlling interest: Investor holds greater
than 50% equity interest
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Investing entity is referred to as the
parent company
Investee entity is referred to as the
subsidiary company
Controlling
ownership)
interest
(more
than
50%
Subsidiary companies are considered
separate legal entities and prepare financial
statements for their own operations.
Under U.S. GAAP, parent companies are
required to issue statements that provide
an overall view of the combined financial
position and operating activities of the
parent and all its subsidiaries as if it is one
single economic entity.
Consolidated financial statements combine
the assets, liabilities, revenues, and
expenses of a subsidiary and its parent
company.
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The process of developing long-range goals
for an organization and defining the
strategies and policies that will help the
organization achieve those goals.
A mission statement articulates the entity's
reasons for existing and serves as the
foundation for the organization's strategic
plan.
A vision statement establishes a forwardlooking view of the ideal state of the entity.
The strategic plan becomes the blueprint
for the organization to follow in order to
achieve its goals, objectives, mission, and
vision.
Time Frame
Strategic planning typically involves a time
frame ranging from three to five years.
Capital expansions often require even
longer time frames.
Strategic plans are contingent upon the
ability of a company to translate the plan
into desired results.
Attributes of successful strategic plans
include:
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Accurate assessments of a company's
current condition and assumptions
about future trends
Comprehensive and significant
Flexible and adaptable
Goals that are specific, measurable,
achievable, realistic, and timely
(SMART)
Supported by leaders and employees
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Continual monitoring and review of
the strategic plan
Emphasis on meeting objectives of
the plan and commitment to
achieving outlined objectives
Plan supports the mission and vision
of the company and capitalizes on
core strengths
Easily understandable and results are
reported to employees to gauge
progress toward achievement
Focus, discipline, and commitment to
achieving objectives
External Factors
External factors affect the direction and
ultimate success of a strategic plan. These
factors are beyond the control of
management but must be factored into
planning.
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Economic conditions
Political stability
Market competition
Legal/regulatory environment
Technology
Climate
Demographic
Media
An evaluation of the external factors helps
an entity take advantage of opportunities,
work around potential limitations, and react
to threats.
Opportunities represent situations in which
the entity can take advantage of a potential
benefit.
Limitations represent constraints that may
reduce the ability of an entity to achieve its
goals.
Threats represent potential issues that
could limit profitability and impede
success.
Internal Factors
Internal factors are within the control of a
company. The assessment of internal
factors includes the following:
Market Penetration
An analysis of expansion into new markets
or focus on expansion in existing markets.
Management and the leadership team
Organizational structure and culture
Human resources
Financial status and asset base
Tactical Plans
Operational and tactical planning is the
process of determining the specific
objectives and means by which strategic
goals will be achieved.
An evaluation of the internal factors helps
an entity identify strengths, weaknesses,
and competitive advantages.
Tactical plans are short-term and cover
periods up to 18 months.
•
•
•
•
Strengths represent core competencies of
an entity, which create a competitive
advantage in relation to its peers due to the
given circumstance or condition.
Weaknesses represent disadvantages of an
entity in relation to peers.
The identification of weaknesses is
important;
however,
competitive
advantages are developed and maintained
by focusing on strengths.
Long-Term Mission and Goals
Long-term planning is the map the
organization creates for the future and
typically covers a period ranging from 3 to
10 years and should capture the following
items:
Porter's Strategies
Michael Porter's generic strategies describe
three potential strategic directions for any
company or business, including:
•
•
•
Cost leadership
Differentiation
Focus/niche
Product Lines
An analysis of existing products and
profitability
of
each,
along
with
considerations including potential new
lines of business, capacity issues (if any),
and the discontinuation of unprofitable
lines.
Business Diversification
An analysis of new markets, products, or
industries for potential opportunities that
could be further developed.
Cost Leadership
Cost leadership focuses on a company's
ability to produce and sell its product for
less than rival companies, which creates a
competitive market advantage.
Companies can use this competitive
advantage in one of two ways:
The company can build market share by
lowering the price of its product below the
prices set by competitors.
The company can also match the pricing of
rival companies for products and capitalize
on the ability to provide goods and services
at reduced costs, which increases profits.
When cost leadership strategies work well:
In markets where buyers have
amounts of bargaining power.
large
In
markets
with
substantial
price
competition where companies can influence
buyers to switch by cutting prices. Cost
leadership does not work well when
companies focus on cutting costs and
overlook technological advances (buyers
have less price sensitivity to brands that
have good technology).
Differentiation Advantage
Differentiation strategies work well in
markets where customers perceive the
company's product to be superior and are
therefore willing to pay higher prices.
The company can build market share by
lowering the price of its product and cover
premiums with the increased customer
base as a result of reduced pricing.
The company can also increase the pricing
of its product at points that offset or exceed
the value perceived by the customer.
When differentiation strategies work well:
In markets where buyers can see the value
in the product, the appeal of the products
attracts buyers for varying reasons, and
competing companies choose different
features to differentiate their products.
Differentiation does not work well when
consumers do not see the value in relation
to premium. Additionally, if the customer
base is indifferent to the unique features,
customers will bypass the product and elect
to purchase lower priced, more generic
goods.
Focus/Niche Strategies
In focus or niche strategies, companies will
focus on a select or smaller group of
customers within a market.
Companies focus on specialized needs of a
certain market/customer base in lieu of
attempting to attract an entire customer
base.
When focus/niche strategies work well:
In markets where the focus group is large
enough to create profits for the company.
In markets where competitors are unable to
either compete in price or address specific
needs through specializations required by
the niche group.
When focus/niche strategies do not work
well:
If competing companies are able to
successfully enter the market and attract a
portion of the customer base.
These strategies also fail when customers
do not require specialized features and
prefer the existing products in the market.
Planning Tools and Techniques
•
•
•
•
•
•
•
•
SWOT analysis
Porter’s five forces
Situational analysis
PEST analysis
Scenario planning
Competitive analysis
Contingency planning
BCG growth-share matrix
Planning Tools and Techniques: SWOT
Analysis
Strengths, Weaknesses, Opportunities, and
Threats (SWOT) analysis involves the
analysis of both internal and external
factors in developing the strategic plan for
a company.
Planning Tools and Techniques: Porter's
Five Forces
Michael Porter's five forces have a
significant effect on the competitive
environment and profitability of a company.
The barriers to entry can also motivate
existing companies to keep their existing
price structures at competitive levels.
Porter's
Five
Competitiveness
Competition)
Market competitiveness is often the most
significant of the five forces for a company.
Market competitiveness can be evaluated in
the context of the following factors:
•
The five forces include:
•
•
•
•
•
Barriers to entry
Market competitiveness (intensity of
competition)
Existence of substitute products
Bargaining power of the customers
Bargaining power of the suppliers
•
•
•
•
Porter's Five Forces: Barriers to Entry
The barriers to entry represent the hurdles
new companies entering the market must
overcome in order to operate.
Barriers to entry come in various forms
including: government regulation; up-front
capital requirements; preexisting customer
preferences and loyalties; learning-curve
issues; and other competitive costs
including patents, trade barriers, and any
other restrictions.
New companies will attempt to enter when
the barriers to entry are low and the
potential for profits exist, and the risk of
retaliation by rival companies is low.
When opportunities for profits exist other
companies will attempt to enter the market,
and as new companies enter the market
profits will fall to a competitive level.
Forces:
Market
(Intensity
of
•
•
The ability of rival companies to
respond to changes and the amount
of money spent on advertising
The
level
of
research
and
development of rival companies
Existing alliances between rival
companies and suppliers
Markets with slower growth rates
Numerous, equal-sized companies
exist within the market to serve
customers
Customers do not have strong brand
preferences
Costs of exiting the market are in
excess of the costs to continue
operating within the market
Porter's
Five
Forces:
Substitute Products
Existence
of
The existence of substitute products in a
highly competitive environment will affect
the ability of the company to sustain
profits. Companies must evaluate the
sensitivity of the demand for products
based on changes in price.
If customers perceive no difference
between
substitute
products,
price
increases will result in a reduction in
demand for the good.
If few substitutes exist within the market,
price increases will not have a substantial
effect on the demand for the good.
Porter's Five Forces: Bargaining Power of
Customers
When buyers within a market are in a
position to negotiate with suppliers on the
conditions of service, price, and quality,
they possess a strong force within the
competitive environment of the company.
Examples of customer bargaining power
include:
•
•
•
•
The existence of high buyer
concentration
The availability of information to
buyers within the market
The ability of a buyer to change
suppliers with relatively low costs
associated with the change
The number of suppliers within the
market are high
Porter's Five Forces: Bargaining Power of
Suppliers
When suppliers within a market are in the
position to change the prices of inputs into
production for companies, they possess a
strong force within the competitive
environment of the company. Examples of
the bargaining power of suppliers include:
The inability of a company to change
suppliers.
The reputation of a supplier, which requires
companies to purchase inputs from the
supplier in order to meet quality demands
necessary for the company's products.
If the demand for inputs from suppliers are
high, price negotiations are more complex.
If suppliers have existing established
relationships and strategic alliances with
other companies, obtaining inputs can be
more difficult.
Planning
Tools
and
Situational Analysis
Techniques:
Situational analysis is a broad term used to
describe the method used by managers to
analyze an organization's internal and
external
environment
to
better
understanding
the
organization's
capabilities, its customers, and its business
environment. Examples of situational
analysis include:
•
•
SWOT Analysis
Competitive analysis using Porter's
five forces
This form of analysis helps an organization
understand the risks and benefits
associated with a specific course of action
within the context of internal and external
factors that affect the success of an entity.
Planning Tools and Techniques: PEST
Analysis
A PEST analysis is a tool used to identify,
assess, organize, and keep track of
macroeconomic factors that can potentially
affect operations currently and in the
future. Macroeconomic factors are broad
elements that impact the overall market
and are outside of the control of an
individual entity.
Planning Tools and Techniques: Scenario
Planning
Scenario planning requires forecasting and
creating alternatives for the future. Under
each scenario, estimates of revenues and
costs are made and a plan is in place to
which the organization can adapt in the
event that each forecasted scenario occurs.
Forecasted scenarios should consider the
following:
Planning
Tools
and
Contingency Planning
The likelihood of occurrence (most to least
likely)
Contingency planning addresses the need
for the development of an alternative plan
in the event that adopted plans do not
work, assumed variables prove to be faulty,
or objectives are impractical or irrelevant.
Outcomes should range from positive to
negative
If a company only creates scenarios in
which positive sales growth exists, no plan
will be in place to handle a downturn in
sales.
Planning
Tools
and
Competitive Analysis
Techniques:
A competitive analysis studies a company's
competitors in order to better understand
their strengths and weaknesses in relation
to its own. The analysis assists a company
in determining areas for improvement and
opportunities for differentiation.
The analysis will attempt to answer the
following questions:
What products/services are
offered and how are those
marketed?
currently
products
What are the strengths and weaknesses of
the company and its current strategies for
growth?
What share of the market does the company
currently hold? Is the company gaining or
losing market share? What are potential
threats?
Are there opportunities to address an
unmet consumer demand?
What drives the success of the company and
are there any mistakes made that we could
avoid making?
Techniques:
Characteristics of Contingency Planning
Contingency plans are developed around
the probability that variables or premises
used in the development of strategic plans
and tactical plans are not valid.
These plans attempt to determine the effect
of changes in variables and evaluate
corrective actions to deal with the impact of
those changes.
These plans focus on the ability of a
company to respond to changes in product
or adapt to new markets as the situations
arise.
Contingency planning is crucial in
maintaining competitive footing in a
changing business environment. The
identification of the variables that make up
the strategic plan and how those variables
affect the contingency play is an integral
part of contingency planning.
Planning Tools and Techniques: BCG
Growth-Share Matrix
The BCG (Boston Consulting Group) growthshare matrix is a method of analyzing a
portfolio of products or businesses based
on growth and market share to assist
companies in making decisions regarding
whether to sell, keep, or invest additional
resources into a product or service. The
matrix consists of four categories: dogs,
cash cows, stars, and question marks.
1B. Budgeting Concepts
Operations and Performance Goals
The Role of the Budget
Budgeting serves as a roadmap for
achieving the strategic objectives and for
the
overall
planning
set
by
the
organization.
Master budgets communicate criteria for
performance and should be established in
alignment with overall strategic objectives.
Budgeting serves to control operations in
order to meet short-term objectives in the
following ways:
•
Budgets help in:
•
•
•
identifying priorities;
allocating resources; and
ensuring that the organization's
plans are financially feasible.
Budgeting provides the financial framework
to support the broader overall planning
process and not only guides day-to-day
decisions but also aids in assessing the
feasibility of the strategic plan.
Budgeting is an integral part of the planning
and control process. A budget:
•
•
•
•
Outlines the quantitative plans of an
organization
Follows the strategic plan to help
achieve
objectives
of
the
organization
Allows an organization to investigate
variances from budget and establish
planned responses
Creates accountability for achieving
budgetary goals
Short-Term Objectives
Short-term objectives are shaped by
strategy, previously achieved results, and
expected or desired outcomes.
A master budget outlines specific operating
performance goals for one year or less
(typically). The budget is broken down into
both an operating budget and a financial
budget.
•
•
Promoting
the
alignment
of
individual and organizational goals
(goal congruence)
Developing incentive compensation
plans
Establishing standards based on
relevant production ranges
Measuring Performance Against Goals
Planning requires an organization to
establish goals that are defined and
therefore able to be measured. Goals can be
financial, customer-focused, developed for
business processes or human resources,
and consistent with critical success factors.
Performance
measures
become
a
quantifiable means of assessing the
achievement of goals.
Budgets are based on the objectives and
goals of management and staff.
Actual performance during the period is
frequently
compared
with
budgeted
amounts.
Comparisons between actual and budgeted
performance provide insight into the
achievement of objectives and goals set by
the organization.
Performance Evaluation
Performance evaluation is the process of
determining the degree of success in
accomplishing a task in terms of both
efficiency and effectiveness.
All employees are subject to performance
evaluation.
A budget is a financial performance goal.
Budgets are compared with actual results
and used for performance evaluation.
Internal Factors
Internal factors influencing the planning
and development of the budget include:
•
•
•
•
Management and leadership team
New product development and
marketing efforts
Organizational structure and culture
Financial status and assets
cannot be changed by the manager whose
performance is evaluated, and therefore
management should not be accountable for
these costs. Examples include:
•
Rent, insurance, and depreciation
Characteristics of Successful Budgeting
Processes
Successful budgeting processes have the
following characteristics:
Communication
─ The budget process and budget details
are
communicated
throughout
the
organization.
External Factors
Established Process for Resource Allocation
External factors influencing the ability of a
company to execute its budget and
strategic plans include:
─ Limited funds available require that
management be methodical and careful
about where budget funds are allocated.
•
•
•
•
•
•
•
State of the economy and political
environment
Market competition
Legal/regulatory environment
Technology
Climate
Demographics
Media
Controllable Costs
Managers should be held accountable for
all controllable costs. Controllable costs are
identified in the budgets for strategic
business units and evaluated in comparison
to standards.
Common controllable costs include:
•
•
•
Direct materials
Direct labor
Advertising, supplies, and travel
Uncontrollable costs are costs authorized at
a different level in the organization that
Personal Participation and Ownership
─ Involvement of the individuals who are
held accountable by the budget creates an
atmosphere of personal ownership for the
budget. The budget becomes a tool to
achieve success rather than a measurement
of
performance
imposed
by
top
management.
Employee Perception
─ Perception that the budget is a tool to
assist in meeting performance objectives,
instead of placing blame, makes the budget
more effective.
Goal Orientation
─ Top managers should use the budget to
properly and positively communicate goals.
Accuracy of Information
─ Use of logical, complete, technically
correct, and accurately computed data adds
credibility to the budget and contributes to
its success.
3. Determining where those resources are
most efficiently deployed.
Consistent With a Time Frame and Process
Appropriate for the Budget Type Deployed
Participation
─ There are several budget methodologies
that an organization can choose, with each
following a unique timeline and process.
Communication
The budget processes and budget details
must be communicated throughout the
organization in order to coordinate
activities between organizational units.
Budgets establish and describe the
operating requirements of each division
and therefore serve as a means of
communication of the expectations from
one division to another.
─ For example, estimated sales forecasts
influence the development of production
budgets, which consequently influence
direct material, direct labor, and overhead
budgets.
Performance
in
comparison
to
standards/budgets is often communicated
through monthly financial statements and
variance analyses to show performance
during the period relative to established
standards.
The
communication
between
organizational units is a critical factor in the
achievement of short-term objectives
established in the planning process.
Resource Allocation
Budgeting is used to allocate and manage
limited resources. The planning process
involves:
1. Reviewing strategic plans and objectives;
2. Assessing available resources; and
Participatory budgeting is an approach that
encourages wide participation by the
individuals affected by the budget. Two-way
communication is required, as budgets are
negotiated between management levels.
Advantages
System
of
a
Participatory
Budget
Employees are motivated and stimulated to
think creatively.
Employee productivity and morale are
boosted.
Employee ownership of goal achievement is
increased because of direct involvement in
the development of budgets.
Comprehensive input helps align individual
goals and organizational goals.
Budgets are more likely to be realistic.
Job satisfaction and fulfillment is often
experience by budget participants.
Employees view themselves as part of a
team.
Employees gain valuable insight into the
overall
goals
of
the
organization.
Disadvantages of a Participatory Budget
System
Competing priorities within departments
can distort corporate objectives.
The budget process may be slower and
more expensive.
Conservative projections could lead to
budgetary slack in order to boost future
performance evaluations.
Management's Role
Top management must be involved in the
budgeting process, including setting the
organization's goals at the beginning of the
process and communicating information,
assumptions, and approval throughout the
process.
The rationales for
involvement include:
top
management
Communication
─ The budget is used to communicate
organizational goals to the employees, and
management's involvement should not be
limited to the formal budget establishment.
Participation
─ Budgets that are created as part of a
collaborative, partnership-type process
tend to be much more realistic and aligned
with the goals of individuals and the
collective organization.
Motivation
─ When upper management oversees the
budgeting process, lower-level managers
are less likely to "pad" the budget. This
motivates employees to embrace the
budget and organization goals.
Time Frames
The budget process is complex and there
are many types of budgets an organization
may choose to implement.
The different types of budgets and the
timelines most frequently associated with
each are shown in the table.
Use of Budget Standards
The budget is a tool to monitor operations
and
initiatives.
Once
developed,
management should regularly review (at
least monthly) actual expenditures and
compare them with the budget to ensure
that there are no significant deviations from
that plan.
Deviations should be investigated to
determine both the cause and corrective
actions/adjustments necessary to keep
making progress toward strategic goals and
objectives.
Types of Standards
Standards present revenues and cost on a
per-unit basis. Standards are used in
variance analysis and in flexible budgets.
There are different types of standards:
•
•
Ideal
standards
vs.
currently
attainable standards
Authoritative
standards
vs.
participative standards
Ideal Standards
Participative Standards
Ideal (theoretical) standards represent the
costs that result from perfect efficiency and
effectiveness in job performance. Ideal
standards are forward-looking and tend to
better reflect long-term goals. No provision
is made for normal spoilage or downtime.
Participative standards are set by both
management and the individuals who are
held accountable for achieving the
standards.
An advantage of using ideal standards is
the implied emphasis on continuous quality
improvement (QCI) to meet the ideal.
An advantage of using participative
standards is the acceptance of standards by
workers.
A disadvantage is the demotivation of
employees as a result of using an
unattainable standard.
A disadvantage of using participative
standards is the length of time to
implement because of the involvement of
more people in the standard-setting
process.
Currently Attainable (Practical) Standards
Developing Standards
Currently attainable standards represent
costs that result from work performed by
employees with appropriate training and
experience but without extraordinary effort
and without perfect efficiency.
Properly set standards encourage higher
productivity
and
lower
costs
by
encouraging compliance with policies and
reduction of wasted resources.
A key advantage of currently attainable
standards is the perception that the
standards are reasonable and that
incremental improvement is possible.
A disadvantage is the required use of
judgment and potential manipulation,
which could result in budgetary slack.
Authoritative Standards
Authoritative standards are set by
management without involvement from
employees held accountable for achieving
the standard.
An advantage of using authoritative
standards is the quick implementation of
the standard.
A disadvantage is that workers might not
fully accept imposed standards, and the
standards may result in demotivation of
employees in meeting standards.
Sources of data to develop standards
include:
Activity Analysis
─ Organizations may evaluate each of the
steps necessary to produce the product or
service. This analysis allows management
to identify areas where value is added or
where time and effort are wasted.
Observation
─ Organizations may deploy people to
watch production processes to see how
long a process takes, the number of
employees involved, the intensity of the
process, the materials and machinery used,
and where inefficiencies may exist.
Historical Data
─ Organizations may use historical
information to determine operational
standards. Although the use of averages is
common,
organizations
focused
on
improvement will develop standards that
challenge rather than replicate historical
performance.
Benchmarking
─ Organizations may use the best practices
of other organizations to develop their
standards. Data from trade associations or
other companies as well as information
from companies in different industries that
use similar processes for subcomponent
operations
are
good
sources
for
benchmarks.
Steps to Develop Direct Material Standards
Management and personnel work together
to establish standards. Direct material
standards are developed using the
following steps:
1. Consult operation personnel to come to
an agreement on the quality of the
materials
to
be
used.
2. Consult accounting personnel to
determine the associated cost based on the
quality
of
the
materials.
3. Consult engineering and production
personnel to agree on the quantity of
material appropriate for each unit of
output.
4. Compare the outputs from the steps
above with historical standards to
determine whether the new figures are
reasonable.
5. Share the draft of standards with relevant
personnel to ensure that everyone agrees.
6. Formally issue the standards.
Steps to Develop Direct Labor Standards
Direct labor standards are developed using
the following steps:
1. Assess the type of work involved.
2. Determine the complexity of the product.
3. Assess the skill level of the employees
performing the work.
4. Review the nature of the manufacturing
process to determine where efficiencies
may be gained.
5. Assess the type and condition of the
equipment used in the production process
to adjust time for repair and maintenance
requirements.
6. Determine a reasonable amount of time
needed to produce each unit.
7. Determine the hourly rates associated
with employees performing the work.
8. Share the draft standards with relevant
personnel to ensure that everyone is in
agreement.
9. Formally issue the standards.
Revising Standards
Policies typically allow for budget revisions
when there are significant changes in
budget assumptions. Budget revisions
improve performance evaluations because
expected results are modified for current
conditions. Changes to the budget are
typically
limited
to
significant,
uncontrollable changes.
Standards and Budgetary Slack
Budgetary
slack
is
purposely
overestimating budgeted expenses to
hedge against the unexpected or to pad
budgets to make objectives easier to
achieve.
Most likely to introduce budgetary slack –
middle and lower management
Reasons for budgetary slack include:
Employees
are
concerned
about
implications of unfavorable variances and
the effect it will have on their
compensation.
Economic uncertainty may lead to padding
the budget to avoid the risk of being
personally harmed by the outcomes of
uncertain, uncontrollable events.
1B. Forecasting Techniques
Regression Analysis
Predictive method used to study the
relationship between two or more variables.
The goal is to determine which independent
variables, x, have the most significant effect
on the outcome of the dependent variable,
y.
Can involve one independent variable or
multiple independent variables.
costs will remain constant in total and
variable costs will remain constant on a perunit basis.
Given these assumptions, the total cost can
be estimated for any level of activity.
Multiple Regression
Multiple regression includes multiple
independent variables with coefficients
assigned to each variable.
Can be used to:
Predict the value of the dependent variable
in future periods.
Explain the variation in a dependent
variable as a function of one or more
independent variables.
Simple Regression
Simple regression involves only one
independent variable using the equation:
Multiple regression is appropriate when
multiple factors (multiple independent
variables) drive the outcome of the
equation (the dependent variable, y).
For example, the number of units expected
to be produced in a given month (the
dependent variable) may depend on a
combination
of
several
independent
variables, including:
•
•
Simple regression can be used to estimate
total cost (y), where:
•
•
•
(a)
represents
total
fixed
costs/amount of y when x = 0;
(b) represents variable costs per unit;
and
(x) represents the production output
and is the independent variable.
Within the relevant range, cost behaviors
are assumed to remain the same.
Therefore, within the relevant range, fixed
•
•
the number of working days in a
month;
worker counts and average hours per
workday;
machine capacity; and
materials availability.
Regression: Benefits
Benefits of regression analysis include:
It is easy to use when variables are known.
If a strong relationship exists between the
dependent variable and the independent
variable(s), the equation will function as a
valuable tool for forecasting outcomes.
Simple linear regression only requires the
use of one independent variable.
Multiple regression is generally more
accurate than simple regression, because
most dependent variables are the function
of more than one independent variable.
Multiple regression considers the unique
weight of each independent variable.
Regression: Shortcomings
It can be difficult to determine the
appropriate independent variable(s) and the
strength of the relationship between the
independent variable(s) and the dependent
variable.
Perfectly positive correlation (+1.00)
implies
that
the
dependent
and
independent variables move together in the
same direction.
Perfectly negative correlation (–1.00)
implies
that
the
dependent
and
independent variables move in opposite
directions.
An increase/(decrease) in the independent
variable
produces
an
equivalent
increase/(decrease) in the dependent
variable.
Factors selected as independent variables
may not have a significant impact on the
dependent variable.
No correlation (0.00) implies that the
dependent and independent variables are
not related and movement in the
independent variable cannot be used to
predict movement in the dependent
variable.
The accuracy of a regression equation
varies based on the data used to create the
equation.
A strong correlation does not necessarily
imply that a change in one variable causes
a change in the other (causation).
The more volatile the historical data, the
less likely a single equation will accurately
predict outcomes.
A qualitative question asked about each
independent variable is, "Does this variable
drive the outcome of another variable?"
Coefficient of Correlation (r)
If the answer is no, correlation will not
indicate causation.
The coefficient of correlation (r) measures
the strength of the relationship between an
independent variable (x) and the dependent
variable (y).
The higher the coefficient of correlation,
the more accurate the regression model will
be at forecasting values for the dependent
variable.
The range of (r) is from –1.00 to 1.00
When predicting total cost (the dependent
variable) as a function of fixed costs,
variable costs, and volume (independent
variables), management's expectation is
that the correlation coefficient will be from
0.00 to 1.00.
Coefficient of Determination (R2)
The coefficient of determination, R2,
measures the strength of the relationship
between the independent variable(s), x, and
the dependent variable, y.
The coefficient of determination:
Represents the proportion of the total
variation in the dependent variable
explained by the independent variable(s).
Has a value between 0 and 1.
The higher the R2, the better the fit of the
regression line and the more useful the
regression equation is at forecasting
values.
For example, an R2 value of 0.85 indicates
that the model explains 85 percent of the
variation in the dependent and independent
variable(s). This would indicate that the
regression equation can be used to predict
outcomes with a relatively high degree of
accuracy.
Learning Curve Analysis
Learning curve analysis is based on the
premise that the number of labor hours
required to produce a unit will decline as
experience is gained and production
becomes more efficient.
Increase in speed as production doubles
For the learning curve analysis to be
applied, the activity itself must be:
•
•
•
repetitive in nature;
involve a significant amount of labor
(where efficiencies from repetition
can be gained); and
have little to no labor-force turnover
or breaks in production.
Calculation
Learning curve calculations require time
estimates for production and reflect
decreases in per-unit and average costs as
production increases.
To apply the cumulative average-time
learning model, the calculation begins with
the first unit/batch. As cumulative
production doubles (from one unit to two
units, to four units, to eight units, etc.),
cumulative average time per unit falls to a
fixed percentage (the learning curve rate) of
the previous average time.
Interpretation
The output of the learning curve is used to
interpret the magnitude of efficiency gains
arising from increased production.
Learning Curve: Benefits and Shortcomings
Benefits
Learning curve analysis produces a
graphical and mathematical illustration of
cost savings over time.
A learning curve analysis can help a
company predict costs based on varying
levels of production by assuming that perunit costs will go down as efficiencies are
gained.
The steeper the learning curve the greater
the cost savings.
Shortcomings
The cumulative average-time learning
model requires a doubling of production to
be applied, with the result that other
production quantities, such as three units,
six units, nine units, etc., are not included
in the calculation.
Over time the learning curve flattens,
indicating that opportunities to reduce
costs have diminished and that efficiencies
may already be maximized.
Expected Value
Expected value is the weighted average of
the outcomes of an action in which the
values of the possible outcomes
weighted by their probabilities.
are
Each outcome has value along with an
associated probability, ranging from 0
percent to 100 percent.
The sum of all probabilities must total 100
percent.
To calculate expected value, each value is
multiplied by its associated probability and
the amounts are summed to produce the
total expected value.
Estimating Future Cash Flows
A valuable application of the expected value
technique is the estimation of future cash
flows.
When developing a cash budget, the
amount and timing of inflows and outflows
must be estimated.
If a company estimates that outflows will
exceed inflows over time, it may have to
borrow from a line of credit or identify other
funding sources.
Benefits
Easy to calculate
The only inputs required are the individual
values and their associated probabilities.
Amounts and weights are easily adjusted to
produce a new expected value.
Shortcomings
Expected values are based on estimates at
a specific point in time.
Probabilities are best guesses and, like
estimated values, can easily be wrong.
An expected value is likely to be different
from any of the inputs used to create it.
Analysis method to use if the economy
changes: Sensitivity analysis
1B. Annual/Master Budgets
Annual/Master Budgets
Purpose: Created to provide the overall
budget picture for an entity, consisting of
operating and financial budgets based on
multiple smaller budgets.
Use: Used to provide comprehensive
guidelines and financial targets.
Time Frame: Built to capture activity for a
one-year period (typically aligned with the
fiscal year).
Annual/Master Budgets: Components
1.Operating Budgets
1. Sales budget
2. Purchases budget
3. Production budgets
4. Selling and administrative budgets
2.Financial Budgets
1. Cash and capital purchases budgets
2. Pro forma balance sheet & statement
of cash flows
3.Capital Budgets
Annual/Master Budgets: Development
•
•
•
Strategy drives objectives
Objectives drive the sales budget
Sales drive most other budgets
Annual/Master
Limitations
Budgets:
Benefits
and
Benefits
Most common budget system
Attention given to resources to sustain
sales forecast
High-level view of component budgets
Quick assessment of plan reasonableness
and achievability
Limitations
High-level view confined to one year at a
single level of activity
May not account for seasonality or volume
fluctuations if divided into equal monthly
budgets
Master Budgets: Incremental Changes
Budget changes may result from:
•
•
•
•
Economic changes
Changes
in
the
competitive
landscape
Technological advances
New production efficiencies
Project Budgeting
Purpose: Created to estimate resources
required to complete a large project.
Use: Used to hold people accountable for
spending relative to the budget.
Time Frame: Appropriate for projects that
span multiple time periods.
View over multiple periods allows oversight
of overall spending
Allows for prioritization of project
components when resources are limited
Limitations
Overspending the budget can negatively
impact the rest of the organization
Potential for understating time and
resources needed for the purposes of
gaining approval to proceed
Project Budgeting: Incremental Changes
Incremental changes impact both timelines
and costs:
Project Budgeting: Components
1.Funding Sources
•
•
•
Cash reserves
Donor and grant dollars
Debt or stock issuances
2.Estimated Expenses
•
•
Materials, labor, and overhead
Capital equipment purchases
Project Budgeting: Development
The project budget is directly tied to the
scope of the project.
Includes timetable for administrative
approvals, reviews, and prioritization, as
well as overall timetable for project
completion.
Timing of inflows (sources) and outflows
(uses) is critical.
Historical information and lessons learned
from past projects are critical inputs
Project Budgeting: Benefits and Limitations
Benefits
Frequent adjustments to start and end
dates
Refinements of cost estimates
Calculating an incremental change:
Start with the base project budget
Adjust the timeline and/or cost estimates
accordingly
Activity-Based Budgeting
Activity-Based Budgeting: Development
Purpose: Created to allocate budget
resources toward critical activities.
1.Record main and secondary activities that
incur costs in an organization.
2. Assign costs based on resources needed
by each activity.
3. Separate costs into homogeneous cost
pools (units, batches, products, facilities).
4. Review historical data to accurately
calculate cost pools logically tied to
activities.
5. Identify the cost objects.
6. Forecast activities and related costs for
each cost object.
7. Prepare the budget with costs specifically
linked to individual activities.
Use: Used in tandem with activity-based
costing (ABC) to focus budgets on resourceconsuming activities and total cost
management.
Time Frame: Applied annually, but can be
used for shorter periods.
Activity-Based Budgeting: Components
Activities: Production processes used to
process a job that consumes resources
Resources: Labor, materials, capital, and
other inputs
Resource Drivers: Measures of the quantity
of resources consumed by an activity
Activity-Based
Limitations
Budgeting:
Benefits
and
Benefits
Cost Pool: Collection of cost elements that
have a common cause
Clearly defines the relationship between
activities and outputs
Cost
Object:
Function,
subdivision,
contract, or work unit where costs are
accumulated
Compatible with continuous improvement
efforts
Cost (Activity) Drivers: Factors that
influence or change the total cost of an
activity
Cost drivers should link an activity to the
costs incurred to conduct the activity; e.g.,
number of shipments or weight of
shipments (cost driver) drives shipping
costs (activity)
Forward-looking view
More control over the budgeting process
Limitations
Time and effort needed to assess activities,
determine cost pools, and identify related
cost drivers
Relationship between costs and activities
not always possible to identify
Short-term focus over long-term needs
Zero-Based Budgeting
Nonessential expenses are eliminated.
Purpose: Created to eliminate the carryover
of previous budgeted items that may no
longer be needed or valid in the current
period.
Any legacy costs must be justified (rather
than simply being carried over from a prior
year).
Limitations
Use: Used to hold people accountable for
defending all planned expenditures each
year.
Resource-intensive (annual preparations
and justifications require significant work).
Time Frame: Typically, these are annual
operating budgets.
Longer-term investments (training, R&D)
may be sacrificed for shorter-term
initiatives that tie directly to revenue.
Zero-Based Budgeting: Components
Starts with an expense baseline total of
zero dollars.
The budget is built by adding in expenses
that are needed to maintain operations and
achieve operating or financial goals.
An expense justified in one year is not
necessarily justified in the next year.
Zero-Based Budgeting: Development
1. Establish the cost of existing services in
the upcoming year.
2.Determine
the
budgetary
and
programmatic impact of not performing a
service.
3. Prioritize the necessary services.
4. Select the services to be funded and the
level at which each service is to be provided.
5. Prepare written justifications for all
expenses and be prepared to defend them.
Zero-Based
Limitations
Budgeting:
Benefits
and
Benefits
Budgets are more accurate and efficient
because management is more aware of
inefficient or wasteful programs and
activities.
Continuous (Rolling) Budgets
Purpose: Created to provide a moving
projection of financial operations for a
series of weeks, months, or quarters
immediately ahead.
Use: Used to adapt to regularly changing
circumstances and keep management
involved in budgeting on a continuous
basis.
Time Frame: Generally covers one year at
any point in time.
The lapsed portion of the budget is
removed at the end of each period and a
new portion is added to the end,
maintaining the length of the budget
period.
Information from the current period is used
to adjust forecasted revenues and expenses
for the rolling 12-month period.
Continuous (Rolling) Budgets: Development
To implement continuous budgeting
effectively, several specific conditions are
required:
Overall volume of information must be
reasonable
proactive
Benefits
Allows a company to always have a full-year
forecast in place
Timely adjustments provide more accurate
results because performance is based on
current circumstances
Requires a smaller amount of concentrated
time to prepare
Budget process stays in the forefront
because it occurs so frequently
Continuous (Rolling) Budgets: Mechanics
Management must be
critiquing each revision
Continuous (Rolling) Budgets: Benefits and
Limitations
in
Re-budgeting must be thorough
Time must be allocated periodically to
review actual results and adjust budget
forecasts accordingly
Limitations
May over emphasize short-term results
Timeliness and frequency required may
lead to incomplete analysis
Targets are ever changing, making
performance management difficult
Flexible Budgeting
Purpose: An adjustable economic model
designed to predict outcomes and
accommodate changes in actual activity
based on multiple sales targets and other
input changes.
Use: Answers the question: What should
our revenues, expenses, and operating
income be if we sell X number of units?
Useful for performing variance analysis and
what-if scenario analysis.
Most useful when a significant level of
uncertainty exists regarding sales volume,
when per-unit revenues can be associated
with per-unit costs, and when fixed costs
are constant over the relevant range.
Time Frame: Normally designed for shortterm periods, one year or less.
Flexible
Budgeting:
Development
Mechanics
and
The flexible budget establishes what the
cost should be to produce at a specific level
and what the impact on operating income
should be at that level.
The starting point is the master budget. The
flexible budget uses the same unit sale
price, variable costs per unit, and total fixed
costs as the master budget.
Revenues are calculated using sales units
and a sale price per unit
Expenses are separated into variable (perunit) and fixed (total) amounts
Created over a relevant range of
production, where variable costs per unit
and total fixed costs are assumed to remain
constant
Multiple sales scenarios are then created
Once the flexible budget is established, the
operating income or loss is compared with
the master budget to show the impact
solely attributable to changes in sales
volume.
Flexible Budgeting: Benefits and Limitations
Benefits
Can be displayed for any volume level
within the relevant range.
Comparisons between actual and budgeted
activity are not distorted by volume
differences.
Cost controls are stronger.
Management is able to make decisions
based on actual volume as it changes.
Limitations
Dependent on the accurate identification of
costs and the relevant range; costs must be
predictable and not change on a per-unit
(variable) or total (fixed) level.
Errors in the determination of the relevant
range or inaccurate forecasts can distort
performance evaluations.
1B. Annual Profit Plan and Supporting
Schedules P1
Operating Budget
Sales Budget
Foundation for the entire budget process
•
•
•
First budget prepared
Anticipated sales in units and dollars
Drives the development of most
other components of the budget
Relationship Between Sales Budget and
Other Budgets
Sales Budget
Serves as the starting point for various
interconnected budgets
The sales, production, and selling and
administrative budgets collectively make up
the operating budgets.
Based on the sales forecast, which is
developed using the following factors:
•
•
•
•
•
Production Budget
Linked to the sales budget
Outlines the number of units to
manufactured to meet sales targets
be
Requires consideration of the direct
materials, direct labor, and factory
overhead budgets
These budgets ultimately contribute to the
cost of goods sold budget, providing
insights into the cost structure and helping
ensure production aligns with sales goals,
promoting effective cost management and
profitability.
•
•
Components of the Sales Budget
•
•
Estimated number of units sold
for each product/service
Estimated sales price per unit
Considerations of the Sales Budget
•
Administrative Expense Budget
The sales budget is not only the starting
point for the production budget but is also
the starting point for the sales and
administrative expense budget.
Past patterns of sales
Sales staff estimates
General economic conditions
Competitors' actions
Changes in the company's prices
and product mix
Results of market research studies
Advertising and sales promotion
plans
•
Broken into smaller periods, such as
months or quarters
Should include the impact of
seasonal variations in sales
Production Budget
•
•
•
Shows the units an entity expects to
produce.
Based on expected sales in units, and
– budgeted beginning and + ending
finished goods inventory levels.
Foundation for each of the materials,
labor, and overhead cost budgets.
Inventory in the Production Budget
Ending Finished Goods Inventory: function
of sales volume, risk of stockouts, and cost
of inventory maintenance
Stockouts: company sells all inventory and
cannot
meet
customer
demand
Inventory Maintenance Costs: insurance,
rental fees, storage fees, obsolescence risk
Relationship between sales, production, and
inventory:
Other Factors Impacting the Production
Budget
Policies Regarding Stable Production
The goal should be to minimize production
variability to reduce idle time during low
production times and labor shortfalls
during high production times.
Condition of Production Equipment
Newer Equipment: higher volume
production at a more efficient pace
of
Older Equipment: often slower and needs
more maintenance
Availability of Production Resources
Plentiful resources enhance production
Scarce resources lead to lower production
and sales
Direct Materials,
Overhead Budgets
Direct
Labor,
and
Relationship Between Direct Materials,
Direct Labor, and Overhead Budgets
The production budget drives direct
materials, direct labor, and overhead
budgets.
Direct Materials: raw materials directly
assigned to an individual unit of production
Direct Labor: based on labor hours and
rates associated with the individuals
directly responsible for production
Overhead: fixed and variable production
costs not captured in direct materials or
direct labor budget
Direct Materials Budget:
Inventory and Procurement
Impact
Examples of procurement policies include:
•
•
•
•
•
•
•
•
Procurement objectives
Procurement authority
Procurement procedures
Supplier selection and supplier
diversity
Competitive bidding
Contract management
Ethical standards
Procurement
key
performance
indicators (KPIs)
Direct Materials Purchases Budget
Number of units to be purchased:
of
The direct materials budget is based on:
•
•
•
•
The number of units of raw materials
needed for each unit of finished
product
+ Desired beginning level inventory
– Desired ending level of inventory
Safety stock requirements
o Reliability of suppliers
o Time to receive inventory
Direct Materials
Policies
Budget:
Procurement
Desired inventory levels and procurement
policies play a role in the direct materials
budget.
Procurement policies are the set of rules
that an organization establishes to acquire
raw materials and components for its
production processes.
The effectiveness and efficiency of
procurement policies can have a direct
impact on the direct materials budget.
Cost of materials to be purchased:
Cost of direct materials used:
Direct Labor Budget
Examples of Variable Factory Overhead
The direct labor budget is affected by
several factors, including:
•
•
Skill levels
Contracts and hiring policies
Benefit costs
•
•
•
•
•
Direct labor costs:
Relationship
Between
Production Budgets
Overhead
and
Overhead Costs: Necessary for production;
cannot be directly assigned.
Generally include both fixed and variable
costs
Production budget precedes overhead
budget, as variable overhead varies directly
with production levels
Factory overhead applied using a cost driver
such as labor or machine hours
Overhead Cost Examples
Examples of Fixed Factory Overhead
•
•
•
•
•
Depreciation (buildings/equipment)
Insurance
Taxes
Indirect
labor
(production
supervisors) and associated fringe
benefits
Utilities (flat rate)
Supplies
Indirect labor (quality assurance) and
associated fringe benefits
Utilities (tied to production levels)
Maintenance (tied to production)
Cost of Goods Sold Budget
Cost of Goods Manufactured Budget
Contribution Margin: Amount available for
fixed costs and profit after paying variable
costs
Contribution margin per unit = Selling price
per unit – Variable costs per unit
Increases in variable SG&A reduce the
contribution margin, unless the investment
drives sales higher
Use of the Contribution Margin
Cost of Goods Sold Budget
Understanding contribution margin is
crucial in order for management to make
informed decisions.
The concepts of contribution margin per
unit and total contribution margin are
fundamental in performing breakeven
analysis.
Nonmanufacturing expenses
The contribution margin per unit is used to
calculate the breakeven point, which is the
number of units a company must produce
and sell in order to achieve zero operating
profit or loss.
Can be fixed or variable
Operating Budget
Combination of variable costs, step costs,
and fixed costs
Combines the following budgets:
Selling and Administrative Budget
Selling and Administrative Expenses and
the Contribution Margin
Contribution margin: how much a product
contributes to covering its fixed cost
Contribution margin = Sales – Variable
costs
•
•
•
•
•
•
•
Sales
Production
Direct materials
Direct labor
Overhead
Cost of goods sold
Selling and administration
1B. Annual Profit Plan and Supporting
Schedules: Part 2
Cash Budgets
Ties together all the various components of
operating, capital investing, and financing
activities.
Aligns with operating budgets, such as
sales, purchases, production, and selling
and administrative costs, by forecasting
cash inflows and outflows derived from
these activities.
Aligns capital budgets with available funds
and can provide insight on additional
funding requirements for investing.
Cash is included in the financial budgets on
the balance sheet in pro forma financial
statements, where we can see changes in
long-term debt, common stock, and
dividends being paid.
Cash Receipts
Budgets specify the amount and timing of
cash expected to be collected from
budgeted sales.
Collections stem from current and prior
period sales.
To speed up collection, consider:
•
•
•
•
Payment discounts
Timely billing
Electronic funds transfer
Lockbox systems
Credit Policies: Collections
Credit policy impacts the demand for a
company's products or services.
Credit Period: length of time buyers given
to pay for their purchases
Credit
Standards:
required
financial
strength of customers paying on credit
Detailed projections of cash receipts and
disbursements derived from operating and
capital budgets
Collection Policy: how stringent a company
is in collecting delinquent accounts
Three major sections:
Discounts offered to customers can speed
up receivables collection.
•
•
•
Cash available
Cash disbursements
Financing
Cash Balances
Amount of cash on hand to fund operations
and investments
Balances available for use are limited by:
•
•
Minimum cash-on-hand requirements
Compensating balance agreements
specifying the minimum amounts to
be maintained in bank accounts
Preparation of a Cash Receipts Budget
The relationship between credit policies,
purchasing (payables) policies, and the cash
budget
is
important
to
financial
management.
Credit policies governing the terms offered
to customers can significantly impact the
timing and amount of cash receipts.
The cash budget reflects the timing of cash
inflows and outflows, requiring alignment
with credit policies to predict cash
collections from credit sales accurately.
Cash Disbursements
The
cash
outlays
purchases, including:
associated
with
Cash paid for purchases for the period
Cash disbursements
accounts payable
to
pay
current
Loan payments due in the current period
Payables due and paid in the current period
Current period expenses paid in cash
during the current period
Purchasing policies, including payment
terms with suppliers, directly affect cash
disbursements.
There is a balance between:
•
•
lenient credit terms to increase sales;
and
conservative payables policies.
Timely
payments
from
customers,
influenced by credit policies, contribute to
liquidity, highlighting the relationship
between
credit
and
cash
receipts,
purchasing and cash disbursements, and
the cash budget for effective financial
planning and control.
Purchasing Policies: Disbursements
Purchasing policy can significantly impact
the cash budget.
Companies may want to take advantage of
discounts offered by vendors to pay faster.
Balance the desire to receive the discount
versus desire to maintain cash to fund other
needs.
Discounts may also be available for buying
in bulk (bigger immediate outflow).
Companies may also utilize lines of credit
from the bank if cash is low.
Financing Budget
Used to project any shortfalls in the amount
of cash available to meet needs.
Shows the manner in which excess cash will
be invested to ensure liquidity and
adequate returns.
Financing reflects a company's minimum
cash requirements against its projected
cash on hand after:
•
•
All cash receipts are received.
All cash disbursements are made.
Preparation of Cash Budget
The cash budget shows the planned
receipts and disbursements for the period,
plus any additional financing needs:
Capital Expenditure Budget
Budgets cover capital additions or
continuations of capital projects over a
multiyear period.
Highly dependent on the availability of cash
or credit
Budgets require the development of a time
line and assessment of purchase costs (and
other outflows).
Expenditure timeline to include:
Asset purchase
Associated costs to prepare asset for use
Additional investments over the life of the
asset
Financing comes from borrowing and/or
creation of cash reserve
1B. Top-Level Planning and Analysis
Pro Forma Financial Statements
Used to illustrate goals and objectives in
financial terms.
Visual projection of the effects of budgeting
assumptions on financial statements and
financial ratios.
Three main pro forma statements:
•
•
•
Pro Forma Income Statement: Used to
show expected revenues, expenses,
and profits based on assumptions
today.
Pro Forma Balance Sheet: Used to
identify balances of critical assets
and amounts owed in the future.
Pro Forma Statement of Cash Flows:
Used to show probable cash inflows
and outflows and to align purchases
with available cash.
Prepared from the following budgets:
•
•
•
Sales budget
Cost of goods sold budget
Selling and administrative expense
budget
Pro Forma Income Statement: Strategic
Objectives Evaluation
Strategic Objectives: organizational goals,
long-term
Projected impact of strategic objectives on
long-term financial performance shown via
the pro forma income statement
Compare the pro forma to the actual results
to assess the achievement of strategic
goals.
Preparation of Pro Forma Balance Sheets
and Pro Forma Statements of Cash Flows
Pro forma balance sheet requires forecasts
of:
Cash balances and other current assets (AR,
inventory)
Long-term asset acquisitions and disposals
Anticipated accounts and notes payable
New debt issuances or payoffs impacting
long-term liabilities
Equity, impacted by stock issuances, and
retained earnings
Pro forma cash flow created from: Pro
forma income statement and balance sheet
Forecasting Cash
Short-Term Cash Forecasting
Period: one to three months
Focus on cash to fund working capital
needs.
Timing of cash receipts and disbursements
is critical.
Medium-Term Cash Forecasting
Period: three months to one year
Focus on working capital, investments, loan
needs, impact of credit terms, and
compliance with loan covenants.
Pro formas are a critical component.
Long-Term Cash Forecasting
Period: excess of one year
Focus on long-term liquidity needs and
incorporates strategic objectives, capital
expenditures, impact on ratios, and
resource shortfalls.
Pro formas are used to forecast.
Projections: Impact
Dividend Decisions
of
Financing
and
Effective financial management involves
utilizing financial projections to assess the
need for external financing and to
determine an appropriate dividend policy.
When projected cash inflows from
operations fall short of meeting the
requirements
for
future
initiatives,
companies can explore various avenues,
such as:
•
•
•
•
utilizing lines of credit;
negotiating
extended
payment
periods with vendors;
adjusting spending plans; or
raising additional funds through debt
and/or equity financing.
A company’s dividend policy plays an
important role in shaping the company's
cash position.
Dividends are not mandatory, and the
dividend policy is set and approved by a
company’s board of directors.
Determining the amount and frequency of
dividend payouts is a strategic decision that
directly impacts cash.
Companies must consider the importance
of providing returns to shareholders
against the need to retain funds for
reinvestment in the business.
Balancing external financing and dividend
policies is important.
Aligning these financial decisions with the
company's long-term goals ensures that the
chosen strategies contribute to sustained
growth.
By managing external financing and
dividend policies based on accurate
financial projections, companies can: ─
improve their ability to meet future
obligations; and capitalize on opportunities
for growth.
Benefits
1C. Cost and Variance Measures: Part 1
Budgets and Variances
Variances: Definition and Uses
Used as both a control and a performance
management tool
•
•
Cost center: managers are evaluated
based on differences between actual
and planned costs. Actual < Budget
Revenue center: managers are
evaluated based on differences
between
actual
and
budgeted
revenue. Actual > Budget
Profit center: evaluated based on
differences between actual and
budgeted profits. Actual > Budget
Variance
Budget
Analysis
Using
the
Master
Performance Analysis: Actual to Budget
The master (annual) budget uses a single
level of activity.
Variances compare the master budget with
actual performance.
Favorable variances occur when:
•
•
Actual revenue exceeds budgeted
revenue
Actual expenses are less than
budgeted expenses
Unfavorable variances occur when:
•
•
Relatively easy to calculate
Useful in identifying variances that
require further investigation
Limitations
Variances stem from differences between
reality (actuals) and expectations (budget)
•
•
•
Actual revenue is less than budgeted
revenue
Actual expenses are greater than
budgeted expenses
•
•
Variances due to volume are not
isolated
Variances due to inefficiencies are
not isolated
Flexible Budgets
Budgets presented
volumes
for
multiple
sales
A more accurate reflection of expected
sales, costs, and profits based on actual
output
Variances compare actual performance with
budgeted performance given actual volume
Main question: If I was correct about
everything except my sales estimate, what
would my numbers be expected to look like
at the end of the period?
Sales Variances
Sales Variance Analysis
Sales Mix Variance
Accounts for sales of multiple products with
different contribution margins
Actual revenue and net income may differ
from budgeted amounts even if sales
volume meets projections
Caused by an actual sales mix difference
from budgeted sales mix
Remember: The contribution margin must
be per unit, multiply first total units sold by
CM per unit then difference between actual
and sales mix ratio
1B. Cost and Variance Measures: Part 2
•
Management by Exception
Focus is on areas with the largest variances
between actual results and budget
standards
Effort is devoted to problem areas requiring
further analysis and potential correction
Analysis of variances can
performance improvements
lead
to
Variable
(VOH)
manufacturing
overhead
Favorable (F) variances result in higher
operating income and unfavorable (U)
variances result in lower operating income.
Controllable variances are preventable and
within
management
control,
while
uncontrollable
variances
are
not
preventable.
Standard Costing System
An accounting system aligned with flexible
budgeting that captures standard costs per
unit of output
Standard costs are budgeted for all
manufacturing costs (raw materials, direct
labor, and manufacturing overhead)
Standard input = Quantity of input allowed
for a unit of output
Standard price of a unit of input = Estimated
price per unit of input used in the
production of a unit of output
DM Price Variance – Materials purchased
Standard costing is useful for:
•
•
•
Cost
control
and
improvements
Performance evaluation
analysis)
Simplified bookkeeping
process
(variance
DM quantity usage variance – Materials
used
Variance Calculations Using Standards
Comparisons of actual costs to standards
provide information on the efficiency and
effectiveness of operations.
Variances are typically
manufacturing costs:
•
•
•
Direct Materials Variance
calculated
for
Direct materials (DM)
Direct labor (DL)
Fixed manufacturing overhead (FOH)
Interpretation for DM variances
Favorable Price – purchasing dep was able
to buy materials at a lower price: volume
discount, bought lower quality items
Unfavorable Price – Inflation or supply
shortage increased costs, more expensive
supplier, higher quality materials
Favorable Usage – higher efficiency in
production: better process, higher quality
materials led to fewer defects/work, skilled
labor minimized material waste
Unfavorable rate – paid higher wages due to
overtime labor shortages, more skilled
workers, wage increase
Favorable efficiency – higher productivity,
skilled workers, better training, improved
processes, technology/automation
Unfavorable efficiency inefficient
workflows, poor supervision, machine
breakdowns, untrained workers, lower
quality materials caused production delays
Unfavorable Usage – Inefficiency in
production, low quality material led to
waste/spoilage, strict quality control
rejecting more units
Materials Mix Variance
Direct Labor Variances
Changing relative percentages for materials
creates variances.
DL Rate Variance
Usage of multiple types of materials
requires dividing the materials quantity
variance into mix and yield variances.
Materials quantity mix variances result from
changing the actual mix of materials used
relative to the planned standard mix of
materials.
DL Efficiency Variance
Interpretations of Direct Labor Variances
Favorable rate – lower-skilled workers,
better labor contract (overtime avoided),
lower wage inflation
Materials Yield Variance
Labor Yield Variance (Similar to DM Yield)
Results from changes in the actual total
quantity used for all types of materials
compared with the planned quantity given
the actual output.
Result from changes in the actual total
hours used by all classes of labor relative to
the planned hours allowed for the actual
output.
Labor Mix Variance (Similar to DM Mix)
Usage of multiple labor rates for different
workers requires dividing the labor
efficiency variance into mix and yield
variances.
Manufacturing Variance
One-Way Variance
Labor mix variances result from changing
the weighted average rate for labor due to
changing the actual mix relative to the
standard mix
Two-Way Variance
Three-Way Variance
Variances for Service Companies
Product costs include direct labor costs and
overhead costs.
Labor efficiency and rate variances are very
useful, as spending more time than
anticipated or paying a higher rate per hour
will produce unfavorable cost variances
Selling more services or charging higher
rates than planned will produce favorable
revenue variances
Sales mix and sales quantity variances are
useful when the entity provides more than
one service
Summary for Overhead Variances
Four-Way Variance
1C. Responsibility Centers
Contribution Margin
Types of Responsibility Centers
Measures the excess of revenues over
variable costs
Responsibility centers = strategic business
units (SBUs)
Responsibility centers are classified into
four groups based on how managers are
held accountable for financial performance:
Cost Center: performance based
controlling costs (not exceed budget)
•
•
•
on
Sales of merchandising department
Financial services
Consulting firms
Profit Center: performance based
managing both revenues and costs
•
on
Store location of chain restaurants
Investment Center: performance based on
return on assets invested
•
Controllable margin by responsibility center
= Contribution margin – Controllable fixed
costs (done by management)
Human Resources/IT
Accounting Department
Legal Department
Revenue Center: performance based on
generating revenues (how much was made)
•
•
•
Reflects the dollar amount available to
cover fixed costs with the excess as profits
Subsidiary companies
Common Costs
Common costs are the costs of support
services, such as accounting, IT, and HR,
that are shared by more than one
responsibility center.
Common costs are uncontrollable costs.
Costs of operating a business that cannot
be allocated on any cause-and-effect basis
to any specific user or division.
Examples of common costs are
•
•
Reporting Segments
Responsibility centers can be subdivided
into additional areas of accountability
where managers are held accountable for:
•
•
•
•
•
•
Product lines or service
Geographic areas
Customers
Production Process
Time/Shifts
Distribution
channels
wholesale, retail)
•
Chief executive officer's salary,
Costs of the financial reporting
function
of
the
accounting
department
Costs of the budget department
Common costs should be allocated among
benefiting responsibility centers using one
of the following methods:
─ Dual allocation
─ Stand-alone cost allocation
(agent,
─ Incremental cost allocation
Allocation
of
common
costs
links
responsibility centers to the performance of
the larger organization.
Common Cost Allocation: Dual Method
The dual method, or dual pricing, allocates
variable overhead costs based on utilization
and fixed overhead costs according to
capacity.
Common
Method
Cost
Allocation:
Stand-Alone
Each user department is allocated part of
the common costs based on usage.
Common
Method
Cost
Allocation:
Incremental
The largest department (primary user) is
allocated all the costs it would bear if it was
the only department.
All fixed common costs and a portion of the
variable costs go to the primary user, with
the remaining variable costs allocated to
the other departments.
Issues With Common Cost Allocation
Common costs do not cease to occur
because a segment is discontinued.
All common costs should be allocated to
the segments and are factored into the
prices charged to customers.
Allocation of centralized departmental
costs to benefitting segments should be
fair, reasonable, and transparent.
Segment managers cannot control the
common costs allocated to their areas.
Systems and training are required for staff
to gather the information needed to
allocate common costs equitably.
Reasons to allocate the common costs of a
firm to the individual centers include:
•
•
Proper valuation of inventory
Proper matching of revenue and
expense
•
Desire to show the full cost of
products to aid in pricing decisions
1C. Transfer Pricing
Involves setting a price for a product or
service when an exchange occurs between
different units within the same organization
Most relevant within vertically integrated
organizations where one department
produces component units (intermediary
products) used by another department
Used to determine departmental operating
income
Has no impact on financial statements
because these transactions are eliminated
in a consolidated presentation
Transfer Pricing Methodologies
The five recognized
methods are:
•
•
•
•
•
transfer
pricing
Variable cost
Full cost
Market price
Negotiated price
Dual-rate pricing
Arm’s length transaction: Neither part has
anything to do with the other, fair price
between two parties
Variable Cost Method
Transfer price is set equal to the
incremental variable costs incurred by the
selling unit
Advantages
Useful when the division is operating below
full capacity = no operating cost
Incentivizes managers to buy internally
Disadvantages
Fixed costs are not covered, resulting in a
loss to the selling division
Losses may
performance
managers
reflect negatively on the
of
selling
department
Full Cost Method
Transfer price set equal to variable cost per
unit plus fixed costs of the selling unit
Advantages
Useful when SBUs are cost centers and all
costs must be covered
Easy to implement and understand
Preferred by taxing authorities
Disadvantages
Standard costs must be used to avoid
potential price manipulation
Standard costs require selling division to
bear all inefficiencies as result of
production
Using actual costs may lead to inefficiencies
of the selling division transferred to the
buying division
Market Price Method
Transfer price is the current external selling
price between willing buyers and sellers
Advantages
Optimal method when the market is wellestablished
Easier to comply
transaction standards
with
arm's-length
Incentives for units to remain autonomous
and maintain competitive pricing
Disadvantages
Market prices may not be readily available
External supplier discounts not recognized.
(no bulk discounts etc)
Negotiated Price Method
Transfer price established as a negotiation
between the purchasing manager and the
selling manager
Advantages
Practical and honest approach
Works well when market information is
available and known
Transfer prices should not be set higher
than market prices.
In case of excess capacity the decision rule
for an acceptable transfer price: Variable
cost + Opportunity cost < Transfer Pricing <
Market Price
Internal negotiations are needed to
determine a fair price for both departments
Disadvantages
Effect of International Operations on
Transfer Pricing
Related party negotiations may not meet
arm's-length standards
Operational and Transactional Issues That
Impact Transfer Pricing
Potential asymmetric power and experience
between sides
Expropriation:
the
risk
of
foreign
governments seizing a multinational
corporation's (MNCs) assets may lead a
department in an area with high risk of
expropriation to lower its transfer prices
and profits
Time-consuming
Dual Pricing Method
Selling department records the sale at the
market price and buying department
records the purchase at variable cost
Advantages
Both departments benefit: the seller earns a
profit and the buyer minimizes costs
Encourages internal transfers because
profit is shared between departments
Disadvantages
Adds complexity to the accounting records
Transfers must be eliminated at their
original prices, causing the creation of a
pending account until the transactions are
reduced to zero
Outside Suppliers and Opportunity Costs
The overall profit margin for a company is
negatively impacted when outside suppliers
who charge more than an internal
department are used.
Minimization of Customs Charges and
Tariffs: lower transfer prices reduce the
customs charges and tariffs to be paid by
the importing department
Currency Restrictions: lower transfer prices
limit foreign subsidiary profits and
reduce/eliminate earnings restrictions
Exchange Rate Fluctuation: managers may
set transfer prices designed to protect the
company from fluctuations in exchange
rates
Availability of Skills and Materials: the
availability of skills and materials in a
country may impact transfer prices
Arm's-Length Test: Taxation
The Organization for Economic Cooperation and Development (OECD)'s model
treaty establishes transfer prices using an
arm's-length test.
Transfer prices between units should be
valued in the same manner as third-party
transactions
to
avoid
undervaluing
transactions in order to reduce taxes.
Acceptable Methods
Comparable Price Method: transfer prices
set using the market prices for unrelated
parties
Resale Price Method: transfer price set as
the sale price less the markup associated
with unrelated parties
Cost-Plus Method: transfer price is set as
the cost of production plus normal markup
Advance Pricing Agreements (APAs):
transfer prices set in an agreement between
MNC and taxing authorities
1C. Performance Measures: Part 1
Performance Measures
Alignment With Strategy
Operational goals and objectives for an
entity should align with its strategic
objectives.
Individual employee performance should be
evaluated relative to goals and objectives
for the entity overall.
Performance Assessment
Involves identifying measures (drivers) of
success and tracking performance against
those measure
Measures (both financial and nonfinancial)
should be quantifiable
Examples of drivers include:
•
•
•
•
•
•
•
•
•
Profitability
Productivity
Quality
Inventory management
Preventive maintenance
Performance to schedule
Capacity utilization
Innovation and internal processes
Human resource management
Employee Feedback
To be effective, feedback should be:
•
•
•
•
•
•
Tangible and actionable
Aligned with goals
User-friendly and transparent
Timely
Ongoing
Consistent
Product Profitability Analysis
Used to evaluate profitability for a product
or products at a point in time or over a
given period of time
Unprofitable products may need to be
discontinued or repriced with potential
adjustments to the production process
Marginal
(incremental)
costs
and
opportunity costs must be analyzed to
determine whether to continue to invest
resources
Factors to incorporate into the analysis
include:
•
•
•
•
•
Contribution margin
Avoidable fixed costs
Reallocating capacity for another
more profitable purpose
Impact on sales revenue of other
products (loss leaders may attract
customers to profitable products)
Impact on employee morale
Business Unit Profitability Analysis
Higher-level decisions made regarding
continuing operations or closing segments
or units
Decision
point
involves
comparing
avoidable fixed costs to lost contribution
margins from dropping a segment
Keep the segment if: lost contribution
margin > avoidable fixed costs
Drop the segment if: lost contribution
margin < avoidable fixed costs
Factors to incorporate into the analysis are
the same as the factors for product
profitability analysis
Customer Profitability Analysis
Used to understand profitable customers
and the resources consumed by each
customer
Helps management identify customers who
contribute the most to operating income
and should therefore receive the most
attention
Customers who contribute low margins or
are unprofitable should be converted into
profitable customers or eliminated
Challenges With Profitability Assessments
It may be difficult to accurately measure
costs. Contingent on ability to measure.
Whereas direct costs are easily measured
and attributable to an individual unit,
product, or customer, indirect (overhead)
costs must be allocated using cost drivers.
Investment decisions require accurate
assessments of resources and the timing
and amount of resources needed.
Valuation of assets and liabilities assigned
in business unit profitability analysis can be
challenging.
Conducting Profitability Analysis
Performed by matching product revenues
with product costs
Key considerations:
Allocation of fixed costs
costs
are
Business Unit Profitability Analysis
Performed by matching
revenues and costs
business
unit
Key considerations:
Margin is the difference between total
revenue and total costs.
"Controllable margin" here refers to the
portion of the margin that a company can
directly influence or control through
operational and strategic decisions.
Controllable costs typically include variable
costs and can be adjusted through
management decisions; Materials, labor,
and some overhead.
Controllable margin is a key performance
indicator for many businesses as it
indicates how well a company is managing
its controllable expenses to generate profit
1. Divide the customer base into segments
(needs of customers, product, geography,
demographics).
2. Calculate total revenue by segment.
3. Allocate direct and indirect overhead
costs to each segment and determine the
contribution
margin
by
customer.
4.Analyze customer segments to determine
relative
customer
profitability.
5. Decide which customers to focus efforts
on
and
which
to
let
go.
6. Review strategies to evaluate the overall
effect on company profitability.
Profitability Analysis:
Disadvantages
Allocation of fixed costs
Determining whether fixed
controllable by unit managers
Decisions based on controllable margin
refer to business or financial decisions
where the focus is on controlling and
optimizing margin.
Customer Profitability Analysis: Steps
Product Profitability Analysis
Determining whether fixed
avoidable or unavoidable
Decisions Based on Controllable Margin
costs
are
Advantages
and
Advantages
Maximizing time and resources away from
unprofitable areas and toward profitable
ones
Better understanding of costs for products,
units, and customers
Better data analysis helps managers
understand long-term profitability and
make informed decisions
Disadvantages
High costs to invest in systems that capture
data
Challenging
to
implement
advanced
management
and
cost
accounting
techniques
Risk of dropping unprofitable products or
services to the detriment of customers
Long time period required to truly benefit
from profitability analysis
Profitability Analysis: Nonfinancial Factors
Nonfinancial factors should be considered
before discontinuing a product line,
business unit, or relationship with a
customer, including:
•
•
•
•
•
•
•
Growth and long-term potential
Market share potential
Marketing and advertising
Resource alignment
Leadership and management
Customer loyalty
Network
Results of Profitability Analysis
As a result of
managers may:
•
•
•
•
profitability
analysis,
Change the pricing structure
Identify products to promote
Identify the focus of promotional
efforts
Identify customer segments to target
and maintain
•
•
Identify which customers, products,
or business units to target for
improvement and growth
Take action regarding unprofitable
products,
business
units,
or
customers
1C. Performance Measures: Part 2
Measures of Profitability
•
•
Return on Investment (ROI)
Assessment of percentage return relative to
the level of assets
Good performance measure for investment
SBUs
Useful when measured against a
hurdle rate
Used to compare performance over
several accounting periods
Limitations
•
•
•
Short-term focus
Potentially
misleading
due
to
differences in accounting policies or
valuation methods
Additional investments increase the
denominator and lower the ratio,
creating a disincentive to invest in
new assets
Residual Income
Used to measure the excess of operating
income earned over the return required
Rate of return (hurdle rate) options: WACC,
cost of equity, or a target return
Return on Investment (ROI)—Alternative
Formula
In the numerator, ROI may be calculated
using net income (income after taxes)
instead of operating income
In the denominator, ROI may be calculated
using the amount of investment capital
instead of total assets
Performance measure for investment SBUs
Positive = Meeting standards
Negative = Not meeting standards
Residual Income: Benefits and Limitations
Benefits
•
ROI: Benefits and Limitations
Benefits
•
Relatively easy to calculate
•
Profitability measure based
dollars, not percentages
Straightforward interpretation
on
Limitations
•
Target
rate
subjective
of
return
highly
•
Comparisons are distorted due to
dollar comparisons of units that may
differ in size
Appropriate Usage of ROI and RI
•
•
•
•
Comparing investment opportunities
Short-term decision making
Resource allocation
Communicating
performance
to
stakeholders
Benchmarking performance against
industry standards or competitors
Tracking
marketing
and
sales
effectiveness
Evaluating
capital
expenditure
projects
Start-up and entrepreneurial ventures
RI is suitable in the following situations:
•
•
•
•
•
•
•
•
Evaluating decentralized business
units
Aligning management incentives with
organizational goals
Long-term performance assessment
Investment project evaluation
Identifying underperforming units
Measuring value creation
Comparing
alternative
business
strategies
Shareholder value analysis
Measurement
Profitability
Issues
•
•
ROI is suitable in the following situations:
•
•
•
•
•
Affecting
Large investments in advertising and
promotions for a new product
Significant
gains
on
asset
dispositions (or losses)
Differing methods of depreciation
Other Measurement Issues
•
•
•
•
•
•
Differences in inventory costing
methodologies (LIFO, FIFO, weighted
average, etc.)
Cost allocation methodologies used
for joint assets shared among
departments
Variations in the value of assets used
in rate-of-return calculations
Differences in asset capitalization
policies and thresholds
Using full absorption costing versus
variable costing
Disposition of variances may be
entirely to COGS or prorated between
COGS, WIP inventory, and finished
goods inventory
Balanced Scorecards (BSC)
Balanced Scorecard
Used to gather information on multiple
dimensions
of
an
organization's
performance.
Describes the classifications of the critical
success factors, strategic goals, tactics, and
related measures.
Revenue and Expense Recognition
The strategy of the company must be the
core of the scorecard.
Performance evaluation is used to compare
entities to standards and to each other.
Only the most critical measures should be
included (related to KPIs).
Comparability may be inhibited by the
following revenue and expense recognition
issues:
Balance needed between short-term and
long-term sustainability
•
Non-recurring
income
items
that
distort
Balanced Scorecard Perspectives
Financial Measures: ROA, ROI,
margins, turnover ratios, etc.
profit
Often linked to the four perspectives of the
balanced scorecard
Nonfinancial:
Internal Business Processes: measures of
quality and efficiency
Customer Satisfaction: measures related to
customer retention, repeat visits, etc.
Learning and Growth: measures focused on
training and development of personnel
Characteristics of an Effective Balanced
Scorecard
Balanced scorecard should be used for
measuring
performance
and
setting
rewards.
Top-level managers must be committed to
leading the process.
Scorecard objectives should be in part
based on employee feedback
The scorecard should be communicated to
all employees within an organization.
Employees should understand the links
between the different perspectives on the
scorecard.
Strategy Map
Graphical depiction of a company's strategy
Used to evaluate and review progress
toward the achievement of strategic
objectives
Outlines overall strategic goals and helps
employees see where they fit in the
achievement of overall goals
Critical Success Factors
Performance Indicators
CSFs
and
KPIs
are
complementary concepts.
and
Key
distinct,
but
CSFs are the critical elements an
organization must focus on to achieve its
strategic objectives.
KPIs are used to measure performance and
progress toward strategic objectives.
KPIs can be quantitative or qualitative.
Both CSFs and KPIs are crucial for strategic
planning, performance management, and
decision making in an organization.
Evaluating an Organization Using CSFs and
KPIs
CSFs are the fundamental areas and
activities an organization must excel in to
achieve its mission and strategic objectives.
CSFs can be measured using KPIs.
KPIs are specific metrics that are used to
monitor performance and assess the
effectiveness of strategies to identify areas
that require adjustments.
Useful KPIs provide objective evidence of
progress towards the organization's CSFs.
Management should link KPI and CSF
identification to the four perspectives of the
balanced scorecard.
•
•
Cost Objects
Cost objects (objectives) are resources or
activities that serve as the basis for
management decisions.
Product costs (manufacturing costs)
Direct materials (DM), direct labor (DL),
manufacturing overhead (OH)
Prime costs = DM + DL; Conversion costs =
DL
+
OH
Treated as inventory and part of cost of
goods sold when sold
Period costs (nonmanufacturing costs)
Selling, general, and administrative (SG&A)
expenses and interest expenses
•
Indirect materials (e.g., cleaning
supplies, safety equipment)
Indirect labor (e.g., QA staff,
maintenance workers)
Other indirect costs (e.g., rent,
property taxes, insurance, utilities)
Cost Behavior (Fixed vs. Variable)
Fixed Costs (fixed overhead and fixed SG&A
costs)
Does not change as the cost driver changes
(assuming within the relevant range);
outside of the relevant range or over time,
may change
Varies per unit; total remains constant
Variable Costs (direct materials, direct
labor, variable overhead, and variable SG&A
costs)
Changes proportionally with the cost driver
Treated as expenses in the period incurred
Constant per unit; total varies
Cost Pools and Cost Assignments
Mixed Costs
Cost pools are collections of cost elements
assigned to cost objects using a common
basis of allocation.
Semi-variable costs (contain both fixed and
variable components)
Costs are assigned to cost pools using
direct tracing (direct costs) or allocation
(indirect costs).
Direct costs are easily traceable to a cost
pool or object.
•
•
Direct materials (cost of materials
purchased and used in production)
Direct labor (cost of labor related to
production)
Indirect (overhead) costs are not easily
traceable to a cost pool or object and are
typically incurred to benefit two or more
cost pools or objects.
Time Frame and Cost Classifications
The relevant range is the range for which
cost driver assumptions are valid.
When the cost driver activity is outside of
the range, variable and fixed cost
assumptions for that driver cannot be used
to allocate costs.
In the long run, most costs will be variable.
Analyzing Mixed Costs Using Regression
Analysis
Total costs are separated into their fixed
and variable components for management
to:
•
predict future cost behavior; and/or
•
facilitate
making.
operational
decision
Overhead
may
be
traditional costing
allocated
using
Regression analysis is:
one method used to separate mixed costs
into their fixed and variable components;
a statistical tool that explains cause and
effect relationships and depicts this
relationship in a linear function; and
often used to depict the change in total
production cost (effect) in response to a
change in quantities (cause).
Analyzing Mixed Costs
Regression is used to estimate the
relationship between the dependent
variable and the independent variable or
variables.
Simple linear regression involves one
dependent variable (total costs) and one
independent variable (volume or activity).
Step 1: Calculate the predetermined
overhead rate (Budgeted overhead costs ÷
Estimated cost driver)
Step 2: Apply overhead (Actual cost driver ×
Overhead rate)
Activity-based costing (ABC) may also be
used to allocate overhead.
Variable Overhead Expenses: Allocation
Bases
Examples:
•
•
•
Direct labor hours or dollars
Engineering or testing hours
Machine hours
Units produced
Fixed Overhead Expenses: Allocation Bases
Examples:
•
•
•
Variable Fixed Overhead Allocation Using
Cost Drivers
Cost Drivers and Costs Incurred
Indirect costs are allocated to cost pools or
objects using cost drivers (allocation bases)
such as labor hours, machine hours, units
produced, square footage, etc.
Cost drivers should have a strong
relationship to the incurrence of costs
•
Budgeted usage (machine hours,
labor hours)
Budgeted level of service or operation
(units of production expected)
Physical capacity (total units that may
be produced)
Floor space (e.g., for building
depreciation and property taxes)
Overhead Allocation Methods
Corporate-wide overhead (single overhead
rate)
Applied to all departments using a volumebased cost driver
Costs measured as follows:
Departmental overhead (multiple overhead
rates) Unique cost drivers applied to each
department
Most accurate measurement system
Individual cost driver rate
Individual rates for
within a department
different
activities
Overhead Allocation Methods: Benefits and
Limitations
Corporate-wide overhead (single overhead
rate)
•
•
Easy to use and allocation base is
consistent across entire entity
Overhead costs assigned to activities
may be over- or underestimated
Departmental overhead (multiple overhead
rate)
•
•
More accurate assignment of costs
when there are multiple products
produced in multiple departments
Requires identification and tracking
of cost drivers by department
Individual cost driver rate
•
•
Most accurate method of
allocation
Complex and time-consuming
Information is not timely because actual
costs are not computed until after the
conclusion of the production period
Not useful for strategic
performance measurement
planning
or
Underutilized capacity situations cause
significant fluctuations in per-unit costs
Normal Costing
Uses actual costs for direct materials and
labor and normal costs for overhead
Normal Costs: normally incurred during
manufacturing
Overhead
application
computed
by
applying
a
predetermined
overhead
allocation rate
cost
Cost Measurement Techniques
No fluctuations in overhead costs per unit
Actual Costing
No effect of over- or underutilized capacity
on per-unit inventory costs
Uses
actual
production
costs
incurred
during
Used when cost measurement is required
for a specific job
Provides timely
product costs
information
regarding
Leads to variances because actual overhead
incurred will likely differ from applied
overhead
Standard Costing
Most common measurement system used
Measures the costs the company expects to
incur during production
Aids in cost control and reductions
Provides information for performance
evaluation, planning, and management by
exception
Time-consuming and may be subjective
Differences between actual costs
standard costs will produce variances
and
1D. Measurement Concepts: Part 2
Absorption Approach vs. Contribution
Approach
Absorption Costing
Contribution Margin Ratio: Contribution
margin / Revenue
Benefits
•
•
•
Allows separation and tracking of
variable and fixed costs
Greater reliability of net income as
inventory is not a factor
Contribution margins are isolated
and useful for decision making
Limitation
Required for financial reporting
Does not segregate fixed and variable costs
All manufacturing costs are treated as
product costs and included in inventory and
COGS
Benefit
•
Method required by U.S. GAAP and
IFRS
Limitations
•
•
Inventory
impacts
net
income
because fixed costs are a component
of product costs
Net income is less reliable than under
the variable costing method
Variable Costing (Contribution Approach)
•
Not GAAP and cannot be used for
financial reporting
Absorption Approach vs. Contribution
Approach
Fixed factory overhead
Absorption Costing: product cost (included
in inventory and COGS when sold)
Contribution
Approach:
period
cost
(expensed when incurred; COGS includes
only variable manufacturing costs)
Selling,
general,
expenses
and
administrative
Period costs under both approaches
Effect on income Production = Sales:
operating income equal under both
approaches
Production > Sales: absorption net income
> contribution net income
Production < Sales: contribution net income
> absorption net income
Useful for internal decision making
Joint Product Costing and By-product
Costing (Common Cost Allocation)
Key calculations
Joint Product and By-product Costing
Contribution Margin: Sales price – Variable
costs
Applied when two or more final products
are produced from the same raw material or
input
Requires allocating the cost of a single
process (joint costs) to several final
products
Joint Product
Terminology
and
By-product
Costing
Joint Products: two or more products
generated from a common input that are
significant outputs of the manufacturing
process
By-products: minor products of relatively
small value incidental to the manufacturing
process
Split-off Point: point in the production
process at which joint products can be
recognized as individual products
Joint Product Costs (Joint Costs): costs
incurred in producing products up to the
split-off point
Separable Costs: costs incurred on a
product after the split-off point
Product value is not considered, potentially
leading to a distorted cost allocation
Product profitability is not considered
Relative Sales Value at Split-off Point
Method
Used to allocate joint costs if the sales price
at the split-off point is known or can be
determined
Assigns costs to separate joint products
based on market values at the split-off point
Used when the value of joint products is an
indicator of how costs should be allocated
to products
Considers the value of products, unlike the
physical measure method
Does not work if market prices cannot be
determined easily or if the product cannot
be sold without further processing
Net Realizable Value (NRV) Method
Joint Cost Allocation Methods
1 Physical measure or allocation by unit
volume relationships method
2 Relative sales value at split-off point
method
3
Net realizable value (NRV) method
4 Constant gross profit margin method
Physical Measure or Allocation by Unit
Volume Relationships Method
Method where joint costs are allocated
based on physical measures (quantity,
volume, output in units)
Useful when volume is representative of
costs incurred
Easy to compute and use
Used when sale values at split-off are not
available because there are no markets for
the joint products
Joint costs are allocated based on the NRV
rather than on the sales value
Cannot be used if NRV is negative
(identifiable costs incurred after split-off >
final selling price)
Constant Gross Profit Margin Method
Joint costs are allocated so that each joint
product has the same gross profit margin
Easy to use when inventory volume is high
Can be used even if products require
separate processing costs after the split-off
point
Only theoretical in nature, as each product
in reality would not have the same gross
profit margin
Compute gross profit using the following
steps:
1. Calculate
gross
profit
margin
percentage on all products
2. Calculate the target gross profit
(dollars) for each product
3. Allocate joint costs using the
following formula: Sales – Separate
costs – Target gross profit
By-products
By-products are outputs of relatively minor
value incidental to the manufacturing
process which have relatively low sale
values.
Accounting for revenue from by-products
can take two forms:
Applied to main product as a reduction to
common costs for joint product costs
Miscellaneous Income
1D. Measurement Concepts: P3 Costing P1
Cost Accumulation Systems
Used to assign costs to products and driven
by the cost object involved
Two primary options
•
•
Job costing (when the cost object is a
custom order)
Process costing (when the cost object
is a mass-produced, homogeneous
product)
Cost of Goods Manufactured and Sold
Costs allocated to a specific job as it moves
through the process
Job-Cost Records (Sheets or Orders)
Maintained for each product, service, or
batch of products
Include materials requisitions, labor time
cards, and accumulated overhead records
Job-Order Costing: Benefits and Limitations
Benefits
•
•
•
Useful for customized products or
services
Costs and profitability for each job
are accounted for separately
Management can track and control
costs at the job level
Limitations
•
•
Job Order Costing
Strategic Value of Cost Information
Understanding the true cost of production
helps management set reasonable sale
prices per unit.
Depending on the product (unique and
identifiable or mass produced), the product
costing method chosen can save significant
time and effort.
Overhead allocations are based on the
expected and actual incurrence of costs
Method of product costing that identifies
the job or units or batches as the cost
objective
Used when each unit is unique or easily
identifiable and there are relatively few
units
Time-consuming and costly
Not suitable when similar processes
are repeated to produce a large
volume of products
Process Costing
Method of costing that averages costs and
applies them to a large number of
homogeneous units
Costs incurred are accumulated over a
period of time and divided by the number
of units produced to determine cost per
unit
Cost allocation between ending WIP and
finished goods involves the following steps:
•
•
•
•
•
Use production report to summarize
the flow of physical units
Calculate "equivalent units" of output
Accumulate total costs
Calculate average unit costs based on
total costs and equivalent units
Apply average costs to units
completed and units remaining in WIP
inventory
Process Costing: Key Terms
Units Started and Completed: work is
started and completed during the period
Ending Work-in-Process Inventory (EWIP):
incomplete units at the end of the period
Equivalent Unit
An equivalent unit of direct material or
conversion costs (direct labor plus factory
overhead) is the amount necessary to
complete one unit of production.
Benefits
•
•
•
Limitations
•
Production Report
Captures costs incurred and units produced
and includes beginning and ending
inventory, units started, and units
completed
Number and amount of units and costs
accounted for must equal number of units
and amount of costs charged to the
department
Key Terms
Beginning Work-in-Process Inventory (BWIP):
units not completed at the end of the
previous period
Units Started During the Period: units on
which work started during the period
Units
Completed/Produced/Transferred
Out: units completed during the period
Very useful when homogeneous
products are manufactured
Requires less tracking relative to joborder costing, as individual unit cost
is not required
Used to estimate product costs,
which aids in setting prices
•
•
•
Time and effort required to estimate
percentage completion for work-inprocess
Not suitable for custom orders
Does not always reflect true
production costs and average costs
may be misleading when prices
fluctuate
Does
not
capture
individual
department or worker productivity
Spoilage (or Shrinkage)
Overapplied Overhead: applied overhead >
actual overhead
Normal spoilage
Occurs during regular operating conditions
Included in the standard cost of the
manufactured product
Capitalized as part of inventory costs
Abnormal spoilage
Credit balance in
overhead account
the
manufacturing
Production greater than expected or actual
overhead less than expected
Misapplication of Overhead
Immaterial misapplication
Should not occur under normal operating
conditions
Excluded from the standard cost of the
manufactured product
Expensed separately on the income
statement as a period expense
Overapplied and Underapplied Overhead
Difference between actual and applied
overhead is closed out and offset against
COGS
Underapplied overhead = COGS increased
Overapplied overhead = COGS decreased
Material misapplication difference between
actual and applied overhead results in
adjustments to WIP inventory, finished
goods inventory, and COGS
Underapplied overhead = increases to WIP,
finished goods, COGS
Overapplied overhead = decreases to WIP,
finished goods, COGS
WIP, finished goods, and COGS are adjusted
on a pro rata basis according to their
relative ending balances
Overhead is applied under job costing and
process costing using an overhead
application rate.
Applied overhead is compared with actual
overhead.
Underapplied Overhead: applied overhead
< actual overhead
Debit balance in
overhead account
the
manufacturing
Production less than expected or actual
overhead greater than expected
1D. Costing Systems: Part 2
Strategic Value of Cost Information
Activity-Based Costing
ABC improves allocation accuracy by
highlighting non-value-added activities that
management can eliminate and by focusing
on value-added activities.
Traditional
Allocations
vs.
Activity-Based
Cost
Volume-Based Costing
Traditional costing system with single cost
pool, allocation base, and overhead
application rate
Cost drivers are volume-based (direct labor
hours, machine hours)
Can distort cost allocations to product lines
Appropriate when volume is a significant
and consistent driver of overhead costs
Activity-Based Costing (ABC)
Based on the assumption that resourceconsuming activities drive costs
Indirect costs assigned to products based
on product's demand for resourceconsuming activities
Improves cost
distortions
allocation
by
removing
Appropriate for activities with unique cost
drivers and multiple overhead cost pools
Using Activity-Based Costing
Service companies may present a greater
challenge for ABC application than
manufacturing companies because service
companies do not have significant
inventory or direct labor/materials.
Resource needs can vary significantly,
making ABC's focus on multiple causes
(activities) and effects (costs) a good choice.
Intense competition between service
companies requires a forward-looking view
from a cost and pricing standpoint.
ABC facilitates improved cost and pricing
decisions by allocating costs using cost
drivers and not volume.
Whereas traditional costing provides few
incentives to managers to optimize
activities and resource consumption to
control overhead, ABC helps companies
optimize
activities
and
resource
consumption.
Terminology
Activity: any work performed inside a
company
Activity Centers: any operation necessary to
produce a product
Resource: an element used to perform an
activity
Cost Drivers: activity bases closely
correlated
to
the
incurrence
of
manufacturing overhead costs and often
used as allocation bases for applying
overhead costs to cost objects
Resource Cost Driver: amount of resources
used by an activity
Activity Cost Driver: amount of activity a
cost object will use
Cost Pool: a group of costs or identified
cost center in which costs are grouped,
assigned, or collected
Value-Added Activity: an activity that
increases the overall value of the product or
service
Steps for Activity-Based Costing
Service Costs Allocation Using ABC
1. Identify the activities (unit-level,
batch-level, product-level, facilitysustaining, customer-level).
2. Identify the cost drivers.
3. Accumulate the costs into cost pools.
4. Trace indirect costs to activity
centers.
5. Allocate remaining indirect cost
pools.
6. Divide assigned costs by level of
activity for the cost center.
7. Cost the product.
Activity-Based
Limitations
Costing:
Benefits
and
Benefits
•
•
•
•
Produces superior information for
decision
making
relative
to
traditional costing based on more
accurate cost allocations
Identifies activities that drive costs
and value-added versus non-valueadded activities
Highlights relationships between
activities and contributes to process
improvement and continuous quality
improvement
Cost/benefit analyses, make-or-buy
decisions, contract bidding, and
resource allocations are all more
accurate
Limitations
•
•
•
Cost/benefit
relationship
and
identification of correct cost drivers
may be difficult to establish
Time consuming and costly to
implement relative to traditional
costing system
Ignores nonquantifiable factors
Allocations of Service Department Costs
Service departments provide support to
production departments and to other
service departments.
Service department costs (e.g., HR and IT)
are an input into the production process.
These costs are a part of overhead and
should be allocated to the production
departments that they serve.
Several methods can be used to allocate
service department costs:
•
•
•
•
Direct method
Step-down method
Dual-rate method
Reciprocal method
Direct Method: Application
Each service or support department's total
costs are allocated directly to production
departments
No recognition of service departments'
usage of other service departments
Application rate calculated by taking total
service department costs and dividing costs
by total usage of the department
Rate
applied
to
each
production
department based on its usage
Step-Down Method: Application
Service department costs allocated to
production departments and other service
departments
Application rate includes usage by all
benefitting departments
Dual-Rate Method: Application
Steps include:
Determine the percentage of fixed versus
variable costs.
Appropriate for fully capturing the total
cost of a product from start to finish
Calculate overhead application rates for the
fixed and variable costs.
Multiply the rates by the volume-based
measure for the variable rate and the
relative usage of capacity for the fixed rate.
Reciprocal Method: Application
Considers all reciprocal flows of services
between service departments
Equations established for all departmental
costs and solved using simultaneous
equations
Life-Cycle Costing: Benefits and Limitations
Benefits
•
•
•
Steps include:
1. Determine the percentage of the total
cost driver used by each department.
2. Calculate the total reciprocal costs
attributed
to
each
service
department.
3. Allocate these reciprocal costs to the
appropriate departments.
Life-Cycle Costing
Accounts for costs incurred prior to
manufacturing (upstream costs), costs
incurred during the manufacturing process,
and costs incurred after manufacturing
(downstream costs)
Beneficial for fully capturing the total cost
of a product or service
Expands on traditional and ABC costing by
measuring costs over the entire life of the
product (not just the manufacturing
process) from R&D through the finished
product
Used as a basis for cost planning and
product pricing
Reports costs and profits over the
entire product/service life cycle
Provides information useful for cost
control and pricing/bidding
Useful in circumstances where
upstream costs are a significant
portion of the total cost
Limitations
•
•
Difficulty in estimating product life
and future costs for a long period of
time
Requires considerable time and effort
1D. Supply Chain Management
Supply Chain Management (SCM)
Supply Chain: system of organizations,
people,
activities,
resources,
and
information needed to transfer items from
suppliers to customers
Goods and Services Flow:
•
•
•
•
•
raw material providers
manufacturers
wholesalers
retailers
customers
Functions: planning, sourcing, producing,
and delivering
Goals of Supply Chain Management
Manage inventories at a channel-wide level
and reduce investments in inventory and
total costs
Coordinate planning efforts within the
supply chain
Design and implement compatible systems
between supply chain members
Value Stream Mapping: identify all activities
that add value to customers and
reduce/eliminate those that do not
Flow Design: use customer demand as a
basis for resource allocation
Establish Demand-Pull Systems: design
work processes that reduce inventory levels
Continuous Improvement: continuously
measure performance to perform only
value-added activities and eliminate waste
Lean Resource Management: Operational
Benefits
Reductions in human effort, inventories,
product development times, storage space
needs, waste, and overall costs
Increased customer satisfaction through
timely production and delivery
Production
of
customer-demanded
amounts, avoiding excess storage and
increasing production efficiency
Reduction of non-value-added costs of
reworks, scrap, and defective units
Reduce the number of suppliers
Improved employee morale and supplier
relationships
Share risks, rewards, and information
More time for employee innovation
Manage information technology to speed
physical and information flows
Improved operational income and higher
profitability
Lean Resource Management Techniques
Lean
resource
management
invests
resources only in value-added activities
Focuses on reducing inefficiencies and
waste
Principles
Value Definition: identify what customers
value
Competitive advantages created through
efficiency gains
Just-in-Time Inventory Management
A demand-pull system that consumes raw
materials only when needed for production
and ships finished goods on demand from
the customer
Requires significant coordination and
information sharing among suppliers,
producers, and common carriers
Suppliers manage the inventory and deliver
items and materials only when exactly
needed for production
Benefits
•
•
•
•
•
Reduced or eliminated storage costs
and production setup time
Production scheduling synchronized
with customer demand
Improved coordination with suppliers
who can deliver quality products in a
timely manner
Enhanced and efficient flow of goods
between warehouses and production
Improved efficiency via the use of
skilled employees who can perform
different tasks
Material Requirements Planning System
(MRP)
Computer-based, push-through inventory
management system designed to improve
productivity by scheduling production
based on demand forecasts
Estimated demand for finished products is
the starting point, working backward to
determine inventory and material needs
Used to estimate quantities and schedule
raw material deliveries prior to beginning
production
System based on what materials
needed, how much, and when
are
Information about the materials or parts
available
Lead time to place the order and receive the
materials
Enterprise Resource Planning (ERP)
Cross-functional
enterprise
system
integrating and automating business
processes and systems in manufacturing,
logistics, distribution, accounting, project
management,
finance,
customer
relationship
management,
customer
services, and human resources
Benefits of ERP include improvements to:
•
•
•
•
•
•
•
Outsourcing and Offshoring
Outsourcing
Outsourcing involves contracting services
usually performed internally to an external
provider.
Offshore operations are outsourcing to a
party in a different country.
Common types
offshoring:
•
•
Information needed:
Demand forecasts for the final product
from the annual report
Bill of materials specifying quantity of
materials and parts for each unit
Process efficiencies
Forecasting
Collaboration and connectivity
Standardization and cost reductions
Productivity
Customer service
Competitive advantage over peers
without ERP
•
•
of
outsourcing
and
Information technology
Business processes (call centers and
accounting operations)
Software research and development
Knowledge processes
Outsourcing: Benefits and Limitations
Benefits
•
•
External companies offer specialized
skills and labor flexibility
Operational and cost efficiencies to
using an external entity
Limitations and Risks
•
•
•
•
•
•
•
Lack of controls due to lack of
proximity for offshore operations
Quality risk (products and services)
Reduced productivity, staff turnover,
and labor insecurity
Language skills
Information security
Outsource entity qualifications
Capacity and Costing
Theoretical Capacity
Assumes the company is producing at full
capacity at all times (no accounting for
downtime, work stoppages, or scheduled
maintenance)
Practical Capacity
Less
than
theoretical
capacity,
as
downtime, breaks, maintenance, and
holidays are taken into account
Normal Capacity
Average customer demand for the goods
produced by the company over the last few
years, taking into account fluctuations due
to seasonal and cyclical factors
Master Budget Capacity
Reflects management expectations for the
current budget period and accounts for
sales
and
promotional
campaigns,
competitor market actions, and fluctuations
due to market conditions
Capacity Levels and Financial Statements
Capacity impacts the overhead application
rates, which impact the amount of overhead
costs applied to units produced.
Overapplied or underapplied overhead
amounts are closed out to COGS or
prorated to COGS, WIP inventory, and
finished-goods inventory.
Underapplied overhead closed to COGS only
causes COGS to increase, lowering
operating income.
When variances are applied to all relevant
accounts, operating income, inventory, and
COGS have the same balance regardless of
the capacity level used for the application
rate
Capacity Level and Costing
The capacity level (the denominator of the
fixed overhead application rate) is
controlled by management.
The practical capacity level is used most
often by companies to calculate the
predetermined fixed overhead application
rate.
Use of practical capacity motivates
managers to use excess capacity to develop
new products or lease unused capacity to
others.
With practical capacity, customers only pay
for used capacity, which lowers the cost and
price of the product.
1D. Business Process Improvement
Value Chain Analysis
Strategic tool used to analyze a company's
activities to determine which ones provide
the greatest value
Used to enhance competitive advantage
(superior performance relative to other
companies in the same industry)
Three major analyses:
•
•
•
Internal Costs Analysis: analyzing
sources of profits and costs of
activities to determine internal valuecreating ability
Internal Differentiation Analysis:
analyzing ability to create value
through differentiation
Vertical
Linkage
Analysis:
understanding the activities of
suppliers and buyers of the product
to determine where value can be
created outside of a company's
operations
Steps in Value Chain Analysis
1.
2.
3.
4.
Identifying value-added activities
Identifying cost drivers associated
with each activity
Developing
a
competitive
advantage by reducing costs or
adding value
Exploiting
linkages
and
identifying
synergies
among
activities to gain efficiency and
add value
Developing a Competitive Advantage Using
Value Chain Analysis
Company strategy dictates the approach
Cost Leadership Strategy: focus on costsaving opportunities
Differentiation
Strategy:
opportunities for innovation
focus
on
Cost-saving opportunities
Areas where the company is not cost
competitive and that cannot be fixed
should be restructured, eliminated, or
outsourced
Opportunities
for
innovation
Allocate time for innovation in R&D
Differentiation commands higher sale
prices for the differentiated products or
services
Activities in the Value Chain
Activities in the value chain that create
value are either primary activities or
support activities.
Primary activities enable production and
transform inputs into outputs.
Support activities provide administrative
support to facilitate primary activities.
Reducing or eliminating non-value-added
activities (e.g., machine repair, rework of
defective units) reduces the cost of the
product or service without impacting value.
Business Process Management (BPM) and
Business Process Reengineering
Business Process Management
BPM focuses on continuous improvement of
customer
satisfaction
(internal
and
external)
Promotes innovation,
technology integration
flexibility,
and
Benefits are efficiency, effectiveness, and
agility
Business Process Management (BPM) and
Activities
Five categories of activities:
Design:
determining
how
existing
processes should function once improved
Modeling: introducing variables into the
design
Execution: implementing design changes
and key performance indicators
Monitoring: gathering information
comparing actual to expected
Plan:
design
improvement
Act: continuously commit to the process
and reassess the degree of improvement
BPM:
Selecting
and
Improvement Initiatives
Implementing
Selecting initiatives involves:
•
•
•
Strategic gap analysis
Reviewing competitive priorities and
production objectives
Choosing and implementing an
improvement program
A successful implementation will involve:
•
•
Business activities are evaluated using the
following techniques:
•
Define: original process serves as the
baseline
•
Measure: determine the indicators used to
show a change to the process
Analyze (process analysis): use simulations
and models to determine target or optimal
improvement
implement
process
Check: monitor the process improvement
BPM: Techniques and Framework
and
planned
Do: implement the process improvement
and
Optimization: monitoring data and refining
processes
Improve: select
improvement
the
the
Control: use dashboards and other
measurement
reports
to
monitor
improvement in real time
BPM: Plan, Do, Check, Act (PDCA)
PDCA: framework for process improvement
Visible support from executive
leadership
Direction and resources from internal
leadership
Continual
monitoring
and
measurement via inspections
Internal process ownership and
commitment
Business Process Reengineering (BPR)
Techniques to help organizations rethink
how work is done
Seeks radical change and focuses on
outcomes
Based on the premise of wiping the slate
clean and reassessing the business from
the ground up using benchmarking and
best practices
Linked to overaggressive downsizing and
failure to achieve benefits and goals
originally anticipated
Continuous Improvement (Kaizen)
"Kaizen" refers to continuous improvement
efforts in manufacturing to improve
efficiency and effectiveness through:
•
•
•
•
Analysis of production processes to
ensure resource usage stays within
targeted costs
Reduction of wasted materials and
time required to perform a task
Helps achieve quality goals, increases
customer satisfaction, and leads to
superior innovation
Ideal standards used as a target for
motivational purposes and means for
introducing change
5. Compare performance with the
benchmark.
6. Create a plan of action.
7. Implement the plan.
8. Analyze the results.
Benchmarking and Competitive Advantage
Benchmarking is challenging but also can
be used as a source of motivation for
employees.
Achieving targets can create value and
increase competitive advantage through:
•
•
Best Practice Analysis
Benchmarking is used to compare key
operating metrics to those of other
companies, with a goal of driving
performance improvement to become more
competitive.
Best practices in benchmarking compare
metrics to industry leaders.
Outputs of the process include potential
reductions in production costs, production
time, materials needed, and processing
time.
Internal
benchmarking
involves
comparisons among departments within a
company to determine which ones are
performing most efficiently.
External benchmarking involves collecting
information about a company's competitors
for comparison purposes.
Steps in the Benchmarking Process
1. Prioritize processes.
2. Decide the type and/or company to
use as a benchmark.
3. Document the process.
4. Collect and analyze data.
•
•
•
•
Improved production processes
Tools to measure performance
effectiveness
Identification of best practices
Reduced costs of production
Improved quality
Costs of Quality
Conformance
Costs
and
Nonconformance
Conformance Costs
The costs of ensuring conformance with
quality standards
Consist of prevention and appraisal costs
Nonconformance Costs
The costs of nonconformance with quality
standards
Consist of internal and external costs
Costs of Quality: Prevention Costs
•
•
•
•
•
•
Employee training
Inspection expenses (for materials
coming in)
Preventive maintenance
Product redesign
Process redesign
Search for higher-quality suppliers
Costs of Quality: Appraisal Costs
•
•
•
•
Statistical quality checks
Testing
Inspection for completed products to
be shipped
Laboratory maintenance
Costs of Quality: Internal Failure Costs
•
•
•
•
•
•
Rework costs
Scrap (cost of lost units)
Tooling changes
Costs to dispose
Cost of lost units
Downtime
Costs of Quality: External Failure Costs
•
•
•
•
•
Warranty costs
Costs of returning the good
Liability claims
Lost customers
Reengineering an external failure
Adoption,
bylaws
1E. Governance, Risk, and Compliance:
Part 1
amendment,
and
repeal
of
Declare dividends
Determine officer compensation
Corporate Governance
Hierarchy of Corporate Governance
Fiduciaries (trustee) to act in the best
interests of the shareholders
Articles of Incorporation: filed with the
state in which the company is incorporated
Corporate Rights
Audit Committee
•
•
•
•
Name of the corporation
Name/address of the corporation's
registered agent
Name/address of each of the
incorporators
Number of shares authorized to be
issued
•
External auditor reports directly to the audit
committee
Serves as intermediary between internal
auditors,
external
auditors,
and
management
Rules to run the corporation
Examples include authority of
officers, how meetings are
conducted, and how officers are
elected
Adopted by incorporators/board of
directors
Policies and procedures
•
•
•
Structure for day-to-day operations
High-level policies (authority deleted
to management)
Detailed procedures (e.g., sales
transaction process)
Corporate Rights
Board of Directors
and
Responsibilities:
Composed of three to five outside directors
Bylaws – start to set the ground rules
•
•
and
Responsibilities:
Corporate
Officers
Rights
Conduct the
operation
and
Responsibilities:
corporation's
day-to-day
Selected (and may be removed) by the
board of directors
Also serve as fiduciaries to act in corporate
best interest
Chief executive officer (CEO)
Responsible for overall operations and
performance
Sets corporate vision, mission, and goals
Chief financial officer (CFO)
Responsible for financial operations
Oversight of strategic direction
Includes financial planning and analysis
Oversight of obligations, including accurate
financial reporting
Corporate Rights and Responsibilities:
Managers and Shareholders
Election,
officers
Managers
supervision,
and
removal
of
Assist with day-to-day operations
Responsible for design, implementation,
and maintenance of internal control
•
•
•
Design – figure out what the internal
control should be
Implementation – make sure it works
Maintenance – make sure it keeps
working,
make
adjustments
if
necessary
Responsible for preparation and fair
presentation of the financial statements
Shareholders
Right to vote and to elect/remove board
members
Right to vote on fundamental corporate
changes (e.g., dissolution)
Do not have the right to receive
distributions (unless/until declared by the
board – received by lenders)
Creation of Public Company Accounting
Oversight Board (PCAOB)
•
Section 103: Auditing, Quality Control,
and Independence Standards and Rules
The PCAOB is responsible for overseeing
the
audits
of
public
companies
─ Sets auditing, quality control, and ethical
standards to be used in preparation and
issuance of audit reports
Registered firms must adopt quality control
standards, maintain independence from
issuers under audit, and supervise all audit
work
Audit documentation maintained for no less
than seven years
Concurring or second partner review of
each audit report
Expanded corporate disclosures
Representations required by officers
Audit report must describe the scope of the
testing of internal control structure and
procedures (as required by Section 404)
Harsher fraud penalties
Significant internal control provisions
Section 201: Prohibited Services for SEC
Audit Clients
Additional external auditor rules
SOX Title I: Public Company Accounting
Oversight Board (PCAOB)
and
Composed of five members (two CPAs and
three non-CPAs)
Subject to SEC oversight
•
Duty to register public accounting
firms that prepare issuer audit
reports
Duty to establish rules for audit
report preparation
Duty to inspect, investigate, and
discipline (when needed) firms and
their work
Adopted auditing standards must include:
Sarbanes-Oxley Act of 2002 (SOX)
Section
101:
Establishment
Administrative Provisions
•
A registered accounting firm that performs
SEC audits may not provide the audit client
with the following services:
•
•
•
•
•
Bookkeeping
Financial information systems design
and implementation
Appraisal and valuation services
Actuarial services
Management functions or human
resources services
•
•
•
•
Internal audit outsourcing services
Services as a broker, dealer,
investment adviser, or investment
banker
Legal services or expert services
unrelated to the audit
Tax services are permissible if
preapproved by the audit committee.
Financial statements present fairly, in all
material respects, the financial condition
and results of operations
Assume responsibility for internal controls
Assert that disclosures have been made to
auditors and audit committee about:
•
Section 203: Audit Partner Rotation
Lead partner (final responsible partner) and
reviewing partner must rotate off the audit
engagement every five years
Addresses the potential for impairment of
objectivity due to familiarity
Section
204:
Committee
Reporting
to
Audit
All registered firms must report directly to
the audit committee
•
•
Section 404: Management Assessment of
Internal Control
Each annual report must contain a report
that states:
•
Audit committee must preapprove all audit
and permitted non-audit services
Required reporting to audit committee
Critical accounting policies and practices
used (management must set, audit
committee can approve)
Alternative
accounting
treatments,
ramifications of the alternatives, and the
treatment the firm would prefer
Material written communication between
management and the audit firm
Section 302: Corporate Responsibility for
Financial Reports
Assertions made by CEO and CFO for
annual and quarterly reports:
They have reviewed the report
Report does not contain untrue statements
or omit material information
Significant deficiencies and material
weaknesses in internal controls
Fraud involving management or any
other employee with a significant role
in internal controls
Represent
whether
there
are
significant internal control changes
•
•
Management is responsible for
establishing
and
maintaining
adequate internal control structure
and
procedures
for
financial
reporting
Management's assessment of the
effectiveness of the internal control
structure
and
procedures
for
financial reporting
The
auditor
must
attest
to
management's
assessment
of
internal control.
Section 407: Disclosure
Committee Financial Expert
of
Audit
At least one audit committee member
should be a financial expert.
Financial reports must disclose
existence of an expert or why
committee does not have one.
Financial expert is qualified by:
•
Education
the
the
•
•
Past public accounting experience
Past experience as a financial officer,
accounting officer, or controller
Financial expert knowledge includes:
•
•
•
•
Understanding and application of
GAAP
Experience in preparing and auditing
similar issuer financial statements
Experience with internal control
Understanding of audit committee
functions
Devising and maintaining a system of
internal accounting controls sufficient to
provide reasonable assurance
Complying with the anti-bribery provision,
which makes it unlawful for a U.S. entity or
resident to make a corrupt payment to a
foreign official with the intent of obtaining
or retaining business
A bribe does not need to actually be paid in
order to violate the law, mere promise is
sufficient to violate the law
The Foreign Corporate Practices Act
(FCPA) Overview
The offer, authorization, or promise to
make a corrupt payment is prohibited
Compliance requires following accounting
transparency guidelines.
No materiality threshold
Requires establishing internal controls to
ensure proper reporting and disclosure of
assets.
Role: to provide an independent and
objective assessment of a company’s
practices regarding internal controls,
operations, or other compliance matters
The FCPA applies to
•
•
•
•
•
Employees of the entity
corporations,
partnerships,
limited partnerships,
business trusts, and
unincorporated organizations.
Must maintain objectivity and integrity
Types of engagements:
•
Penalties for violations include up to five
years in prison or up to $100,000 in fines,
or both.
Enforcement is shared by the
Department of Justice and the SEC.
Internal Audit
•
U.S.
Internal Control Provisions of the FCPA
•
Issuers must comply with the specific
accounting and control provisions under
FCPA:
•
Making and keeping detailed accounting
records to reflect transactions of the issuer
accurately and fairly
IT Audits: assess security of
information systems
Operational Audits: evaluate whether
internal controls are effective,
operating procedures are being
followed, and company resources are
being used efficiently and effectively
Performance Audits: evaluate actual
results in relation to goals and
objectives set by the board
Compliance
Audits
(compliance
reviews): ensure adherence to laws,
regulations, and company policies
and procedures
The External Audit
Phases of External Auditing
Overview of the External Audit
The external auditor is hired to provide
financial statement users with an opinion as
to whether the financial statements are:
•
•
•
Presented fairly
In all material respects
In accordance with the applicable
financial reporting framework
Gives credibility to the financial statements
External Auditor Responsibilities
•
•
•
•
•
•
Maintaining professional skepticism
Complying with relevant ethical
requirements
Exercising professional judgment
Obtaining
sufficient
appropriate
evidence
Communicating with management
and those charged with governance
Complying with generally accepted
auditing standards (GAAS)
Reasonable Assurance
An external audit provides high, but not
absolute, assurance.
Engagement Acceptance
External auditor selected by those charged
with governance (e.g., for issuers, the audit
committee)
Auditor should agree to the engagement
terms with those charged with governance
or management, as appropriate
Agreement should be documented in an
engagement letter
Assess Risk and Plan Response
The planning phase of the audit includes:
•
•
The following inherent limitations of an
audit prevent absolute assurance:
Nature of financial reporting (e.g., financial
statements include estimates made by
management)
•
Nature of the audit procedures (e.g., the
use of sampling, management may not
provide complete information)
Timeliness of financial reporting
Determining materiality
Performing procedures to gain an
understanding of the entity and its
environment, including the system of
internal control and the applicable
financial reporting framework
Identifying and responding to audit
risk, which is the risk that the auditor
may fail to appropriately modify the
auditor's
opinion
on
financial
statements that are materially
misstated
Audit risk comprises:
•
Inherent Risk: the risk inherent in
certain accounts and transactions
•
•
Control Risk: the risk that errors will
not be prevented or detected and
corrected by internal control
Detection Risk: the risk that the
auditor will conclude there was not a
material misstatement when there is
one
Audit risk is the ultimate risk we will fail to
modify our opinion because the financials
are materially misstated
If inherent and control risk is high, we have
to do a lot of testing. Drop the detection
risk acceptably low, not zero, because it is
reasonable
assurance
not
perfect
assurance.
Communication and Reporting
Throughout the audit, the auditor should
communicate with management and those
charged with governance.
Required communications include:
•
•
•
Matters related to the auditor's
responsibilities
Planned scope and timing of the audit
Significant audit findings
Errors and irregularities should be
discussed with management at least one
level above those involved.
Audit Opinion
Assess Risk and Plan Response
In order to form an opinion on the financial
statements, the auditor should consider:
The
auditor
should
obtain
an
understanding of the five components of
internal control:
Whether sufficient appropriate
evidence was obtained (GAAS)
•
•
•
•
•
Control environment
Risk assessment
Information and communication
Monitoring
Existing control activities
Perform Procedures and Obtain Evidence
Audit evidence is gathered by performing:
•
•
•
•
Risk assessment procedures
Tests of controls
Substantive procedures
Other audit procedures
The management representation letter is
obtained at the conclusion of the audit
•
•
•
Audit prepares the letter, which is
signed by the client
Final piece of audit evidence
Confirms
oral
and
written
representations
made
by
management
audit
Whether the financial statements are
prepared, in all material respects, in
accordance with the requirements of an
applicable financial reporting framework
(e.g., GAAP)
Financial statements are defined as a
complete set, general purpose, including
related notes
Under U.S. GAAP, a complete set includes
the
balance
sheet,
statement
of
(comprehensive) income, statement of
changes in equity, statement of cash flows,
and related notes.
Audit Opinion: Unmodified
(Unqualified) for PCAOB
for
AICPA
Opinion
stating
that
the
financial
statements are presented fairly, in all
material respects, in conformity with the
applicable financial reporting framework
Unmodified is applicable to non-issuers
Unqualified is applicable to issuers
May
need
to
add
communications to the report:
additional
Explanatory paragraph (issuers): Included
when required by PCAOB standards or at
the auditor's discretion
For non-issuers, emphasis-of-matter and/or
other-matter paragraphs (“PS” note)
For issuers, explanatory paragraph – don’t
change opinion at all
Audit Opinion: Modified
•
•
•
Qualified: Opinion stating that the
financial statements are presented
fairly, except for the material matter
to which the qualification relates
(GAAP or GAAS)
Adverse: Opinion stating that the
financial
statements
are
not
presented fairly due to a material and
pervasive accounting issue (GAAP
only)
Disclaimer of opinion: Does not
express an opinion due to a
significant and pervasive issue that
prevents the completion of the audit
(GAAS only)
Integrated Audit
Integrated Audit Overview
Required for issuers, optional for nonissuers
In an integrated audit, two audits are
performed concurrently, resulting in two
opinions rendered on:
•
•
Emphasis-of-Matter, Other-Matter,
Explanatory Paragraphs
and
Emphasis-of-matter
paragraph
(nonissuers): Refers to an appropriately
presented/disclosed matter important to
users' understanding of the financial
statements
Other-matter
paragraph
(non-issuers):
Refers to matters outside the scope of the
financial statements relevant to users'
understanding of the audit
The fairness of the financial
statements
The operating effectiveness of
internal
control
over
financial
reporting
Two methods to audit the operating
effectiveness of internal controls:
•
•
Top-Down (Risk-Based) Approach:
required approach
Bottom-Up Approach: not permitted
under current auditing standards
Top-Down (Risk-Based) Approach
In an integrated audit, a top-down (riskbased) approach is used to select controls
to test by evaluating:
First, overall risks at the financial statement
level
Second, controls at the entity level
Third, accounts, disclosures, and assertions
for which there is a reasonable possibility
of material misstatement
Advantages
More detailed examination of controls more
likely to result in a material misstatement
More effective at controlling risks
More
efficient
control
testing
PCAOB preferred approach to auditing
internal controls
Top-Down (Risk-Based) Approach
Identify and
controls:
•
•
•
•
•
•
•
•
test
relevant
entity-level
Control environment – if the control
environment
is
not
effective,
everything underneath is suspect as
well where testing loses its value
Management override – best controls
can be undone by management
Risk assessment process
Centralized processing
Monitoring operation results – how
do they control monthly risks
Monitoring other controls
Period-end financial reporting
Policies
addressing
significant
business
control
and
risk
management
1E. Governance, Risk, and Compliance:
Part 2
Framework Objectives
Operations objectives
COSO Internal Control Framework
•
Created by the Committee of Sponsoring
Organizations (COSO)
•
•
•
•
•
American Accounting Association
(AAA)
American Institute of Certified Public
Accountants (AICPA)
Financial Executives Institute (FEI)
Institute of Internal Auditors (IIA)
Institute of Management Accountants
(IMA)
Designed to assist organizations
developing comprehensive systems
internal control
in
of
•
Related to the effectiveness and
efficiency of operations
Include financial and operational
performance goals, as well as
ensuring that assets are adequately
safeguarded
Reporting objectives
•
Pertain to the reliability, timeliness,
and transparency of both internal and
external financial and nonfinancial
reporting
Compliance objectives
•
Framework updated in 2013 to incorporate
changes in technology, business models,
globalization, outsourcing and regulation
Established to ensure adherence to
applicable laws and regulations
COSO defines internal control as:
A process designed and implemented by an
organization's management, board of
directors, and other employees to provide
reasonable assurance that the organization
will achieve its operating, reporting, and
compliance objectives
The COSO cube depicts the relationship
between entity objectives, internal control
components, and organizational structure.
Weak control environment
control environment is weak
=
internal
Components of Internal Control: Control
Environment
Processes, structures, and standards that
provide a foundation for an internal control
system
The five principles related to the control
environment are:
•
•
•
•
•
Commitment to ethics and integrity
Board independence and oversight
Organizational structure
Commitment to competence
Accountability
Components
Assessment
of
Internal
Control:
Risk
The three principles related to control
activities are:
Entity's identification and analysis of risks
to the achievement of its objectives
•
•
The four principles
assessment are:
•
•
•
•
•
related
to
risk
Specify objectives
Identify and analyze risks
Consider potential for fraud
Identify and assess changes
Components
of
Internal
Information and Communication
Overview of Internal Control Risk
Control:
Systems support the identification, capture,
and exchange of information in a timely and
useful manner
The three principles related to information
and communication are:
•
•
•
Obtain and use information
Internally communicate information
Communicate with external parties
Components of Internal Control: Monitoring
Activities
Process of assessing internal control
performance over time by assessing the
design and operation of controls on a
timely basis and making necessary
corrections
The two principles related to monitoring
activities are:
•
•
Select and develop control activities
Select and develop technology
controls
Deployment
of
policies
and
procedures
Ongoing and/or separate evaluation
Communication of deficiencies
Components of Internal Control: (Existing)
Control Activities
Set forth by entity policies and procedures
Controls may be preventive or detective and
may include automated and manual
activities
Risk that internal control policies and
procedures will be insufficient to support
operating, reporting, and compliance
objectives
Limited to reasonable, not absolute,
assurance due to the following inherent
limitations:
•
•
•
•
Management override
Human error in the design or use of
controls
Collusion to circumvent controls
External events beyond the control of
the entity
Risk Assessment and Mitigation
Management should assess control risk and
allocate resources to reduce risks to an
acceptable level
Risk assessment includes review of policies
and procedures and testing the adequacy of
internal controls
Internal control risk is high when there are
no internal controls or established controls
are not operating effectively
Risk responses and mitigation strategies
include:
•
•
•
•
Acceptance/retention
Avoidance
Reduction
Sharing/transferring
Internal
Control
Flowcharts
Assessment
Tools:
Symbolic
diagram
representing
the
sequential flow of processes, documents,
and authority
System flowchart: Shows document origin,
subsequent
processing,
and
final
disposition
Program flow chart: IT flowchart that
documents the logic and flow of a computer
program
Flowcharts should:
•
•
•
•
Show the general flow of data and
documents
Be oriented top to bottom and left to
right
Use familiar, descriptive wording
Avoid intersecting lines
Internal Control Assessment Tools: Other
Tools
Written narratives
•
•
•
Written version of a flowchart
Description of the internal control
system
Appropriate
for
less
complex
systems
Other documentation
•
•
•
Accounting system manuals
Operating system manuals
Organizational charts designating
authority and responsibility
Monitoring the System of Internal Control
Management must monitor the system of
internal control to ensure the relevant
components are present and functioning
Monitoring can be done using separate
and/or ongoing evaluations
•
•
•
Separate evaluations are performed
periodically by a separate and
objective party, such as an internal
audit
Ongoing evaluations are generally
built into business processes to
ensure
control
activities
are
operating as designed
Both types of evaluations can be done
using techniques such as inquiry,
observation, inspection, and reperformance
Independent checks and verification are
important in:
•
•
•
Monitoring
and
assessing
the
effectiveness of internal controls
Testing the adequacy of internal
controls
Helping prevent errors and fraud
Methods to monitor and test the adequacy
of internal controls:
Inquiries should include individuals who
perform the control procedures to confirm
understanding
Inquiry alone is insufficient and should be
combined with other procedures
Observation involves directly witnessing
how
employees
follow
established
procedures
Inspection entails a detailed review of the
written
policies,
procedures,
and
underlying documentation and records
Re-performance involves independently
performing control procedures to validate
their effectiveness
For example, inventory counts might be reperformed to ensure accuracy
Detective Controls
Designed to provide reasonable assurance
that errors and irregularities will be
detected and corrected on a timely basis
In financial reporting, normally performed
after a transaction has been completed
Examples
•
•
•
Safeguarding Controls
Limit access to authorized personnel
•
•
Internal Control Policies and Procedures
Preventive Controls
Proactive measures designed to prevent
errors and fraud
Generally considered the most effective
Should be tailored to meet operational and
industry needs
Preventive controls over financial reporting
are designed to provide reasonable
assurance that only valid transactions are
recognized, approved, and submitted
Examples
•
•
•
•
Employee screening and fraud
training
Segregation of duties
Access controls via passwords and
authentication tools
Physical controls over company
assets
Financial performance review (e.g.,
budget vs. actual)
Conducting a physical inventory
count
Reconciliation of accounts such as
fixed assets or cash
Direct controls refer to physical
access to assets
Indirect
controls
refer
to
authorization to acquire, use, or
dispose of assets
Examples
•
•
•
Lockbox system for cash receipts
Direct deposit as opposed to physical
paychecks
Write-offs of uncollectible accounts
only by credit department manager
Physical Controls
Security devices and limited access to
programs and restricted areas
Examples
•
•
Physical segregation and security of
assets, such as safe-deposit boxes
and independent warehouses
Authorized access to assets and
records such as access codes and
required signatures
•
Periodic counting and comparison of
assets to corresponding accounting
records
Segregation of Duties
Ensure that individuals do not perform
incompatible duties
Work of one individual should cross-check
the work of another
Critical to segregate:
•
•
•
•
Transaction authorization
Transaction record keeping
Custody of related assets
Reconciliation
Any discrepancies can then be investigated
Information
Controls
System
Development
Overview
of
Information
Development Controls
System
Designed to enhance security and accuracy
of inputted data, which strengthens the
validity of system output
Controls are designed to protect against
internal and external threats
Controls must be adaptable
environment changes
as
the
Input Controls
Ensure that data entered is factually
accurate and properly authorized
Credentials must be entered
authorized users can input data
before
The following second-layer controls ensure
that data meets established parameters
Independent Checks and Verification
Verification of work performed to:
•
•
Ensure accuracy
Prevent errors and fraud
Examples
•
•
•
Bank reconciliation
Comparing accounting records to
supporting documents
Comparing physical inventory counts
to related records
Prenumbered Forms
Used to ensure that all transactions are
accounted for and no transaction is entered
more than once
Allows each transaction to be sequentially
numbered, with any unused numbers
properly voided
•
•
•
Technical structure of files
Data types (e.g., text or number)
Field checks (e.g., numerical upper
and lower limits)
Processing Controls
Ensure that transformations from input to
output are handled properly and that data
communication is secure
Audit trail: Records the steps within a
process in order to be reviewed by other
employees or auditors
System processing security includes:
•
•
•
Credentialing for report files
File encryption
Secure communication
Output Controls
•
Ensure that processing results are
presented in a useful state to authorized
persons.
Credentialing, secure file transmission, and
file encryption protect output from misuse
and theft.
Recommended that output is presented in
industry-approved formats/standards.
Output controls should also be triggered
by a risk or unusual process-generated
recommendation.
Ensure that appropriate records are
retained, retrieved, and accessed by
authorized people and processes
Physical controls: Secure physical location
of the data
Credentialing: Ensures authorized access
Encryption:
Protects
data
unauthorized retrieval and use
from
Duties
and
All systems should be designed to facilitate
segregation of duties.
The information system tackles record
keeping
Security in information systems depends
on:
•
IT can set limits on each employee's ability
to use program elements
Programs maintain records of actions taken
and who took them
Safeguards to prevent inappropriate
changes to programs and databases
•
•
Version controls that allow one
change at a time, incorporating
changes sequentially
Access controls that allow changes
only by authorized users
Validity controls that allow only
permissible data types
Threats to Information System Security
Preventive controls over physical systems
Log-in credentials
Security against physical theft
Servers should be in locked facilities with
restricted access
Version controls
•
Access to data linked to employee log-in
credentials
•
•
Backups
Segregation of Accounting
Systems Security
Information System Security
•
Storage Controls
Other functions to check for proper
authorization and record keeping
Proper authorization of transactions
by accountable individuals
Accounting
employees
keeping
accurate transaction records
•
•
Prevents accessing, stealing, altering,
or destroying sensitive data
Lack of physical labeling to make
identification of specific data storage
devices difficult
Peripherals must also be addressed for
potential vulnerabilities
External Threats to Information System
Security
Phishing: E-mails or other communications
are used to coax an employee to provide
access credentials
Trojan horse: Apparently benign program
or application that contains malicious script
or a program designed to steal data, alter
files, or destroy systems
Ransomware: Encryption of data by an
attacker who demands payment to decrypt
the data
Viruses: Programs that invade host
systems, replicate, and hide within the
system while carrying out a mission
Internet Security
Risk posed by transmission through
unpredictable paths even if sent between
two company-owned computers.
Sensitive data should be encrypted to
protect it on the path.
Wireless networks present an additional
vulnerability due to typically weak security
Data Encryption
Typically through a computer algorithm
that encodes data from a readable to
unreadable state
Accomplished through the use of one or
more
encryption
keys
providing
instructions to encode/decode the data
Typically sensitive data employs encryption
Examples of entities that use encryption:
•
•
•
•
Financial services
Banks
Health care providers
Personal financial information users
Firewalls
Network security systems that monitor,
control, and restrict incoming and outgoing
traffic
Selectively allow or deny traffic based on a
set of predetermined rules
May deny access based on:
•
•
•
Origin point of the incoming
communication
Program used to communicate
Internet content
Firewalls can default to either
•
•
Allow: only exclude certain items
from getting through
Deny: only allow certain items
through
Business Continuity Planning
Overview of Business Continuity Planning
Process of creating plans and prepositioning assets to allow a business to
function during and after a business
disruption
Potential disruptions include natural, social,
and economic
Measures
•
•
•
•
Emergency planning policies
Business interruption insurance
Pre-positioning backup data and
hardware
Alternative facilities
Business continuity planning is strategic;
disaster recovery planning is tactical,
representing a significant part of business
continuity planning
Objectives of a Disaster Recovery Plan
Bring the business from disruption to
operation as quickly and effectively as
possible
Timeliness can vary by business and
component
24–48 hours is typical for information
systems infrastructure and financial capital
access
Differential backup: Back up all items
changed since prior full backup; more timeconsuming backup but easier to restore
Longer for something like access to printers
Data Backup and Recovery Procedures:
Alternative Processing Facilities
Data Backup and Recovery Procedures:
Disaster Recovery Service
Providers referred to as
•
•
Disaster recovery as a service (DRaaS)
Managed service provider (MSP)
May provide simple data backup or more
complex services such as
•
•
•
System file syncing
Data loss prevention and recovery
plan coordination
Full IT environment replication
Data Backup and Recovery Procedures:
Internal Disaster Recovery
Expensive option used by organizations
that require instantaneous processing
resumption
Provide duplicate facilities in separate
locations
Provide data mirroring to update and store
data in both locations
Data Backup and Recovery Procedures:
Multiple Data Center Backups
Use of either a data center or a cloud
provider for system backups
Full backup: Exact copy of the entire
database
Incremental backup: Copying changes since
prior backup; restoration starts from last
full backup with each incremental backup in
sequence thereafter
Cold site: Off-site; electrical connections
and physical data processing requirements;
no actual equipment; 1–3 days to operation
Hotsite:
•
•
•
•
Off-site; equipped to quickly take
over data processing; personnel must
relocate to off-site facility to restore
function
Telecommunications network is often
the most challenging aspect
Space and equipment available
reflects diversity of customers and
probability of needed use
Rapid effective recovery requires
knowledgeable personnel
Warm site
•
•
Stocked with hardware needed to
create a data center facsimile
Represents a compromise between
hot-site speed and cold-site cost
Disaster Recovery Team
Includes key operations management
personnel and potentially a disaster
recovery services provider.
If software packages are utilized, software
vendors may also play a role.
If processing is distributed,
vendors may also be involved.
hardware
Most critically, senior management must
support the plan.
Steps in Disaster Recovery
1. Assess risk
2. Identify mission-critical applications
and data
3. Develop plans to handle missioncritical applications
4. Determine personnel responsibilities
in disaster recovery
5. Test the disaster recovery plan
Advantages and Disadvantages of Disaster
Recovery and Business Continuity Plans
Component of overall risk management
Advantage: Ability to continue operations
with minimal disruptions
Disadvantage: Cost and effort required to
establish and maintain such plans
Data Backup and Recovery Procedures
Copies of key files and records should be
stored in safe, off-site locations
Copies of files kept on-site should be stored
in a fireproof room or container
Backup of systems that can be shut down is
relatively simple, can use incremental
backup
Backup of systems that do not shut down is
more
complex,
involves
logging
transactions
and
reapplying
those
transactions to a point preceding the failure
Mirroring requires use of a backup
computer to duplicate all activity on the
primary system
Internal Control Deficiencies
An internal control deficiency exists when
the design or operation of a control does
not allow management or employees, in the
normal course of performing their assigned
functions, to prevent, or detect and correct
misstatements on a timely basis
A deficiency in the design of a control
occurs when a necessary control is missing
or when an existing control does not
achieve the desired outcome
A deficiency in operation occurs when a
properly designed control does not operate
as designed or is performed by an
unauthorized person
Management may become aware of control
deficiencies through an entity's own
monitoring activities or through external
parties, such as an external auditor
Senior management is responsible for
ensuring that deficiencies are identified and
communicated to the appropriate parties
and
that
remediation
plans
are
implemented in a timely manner
The board of directors, often through the
audit committee, works with senior
management to ensure that timely
corrective actions are taken to address
identified deficiencies
Remediating Internal Control Deficiencies
Ultimately,
senior
management
is
responsible for ensuring that policies and
procedures are establishe to support an
effective system of internal control
When
deficiencies
are
identified,
remediation plans may include:
•
•
•
Additional training for personnel
Implementation of new control
activities or policies
The assessment of resources needed
to carry out a process more
effectively
Accounting Information Systems (AIS)
Type of management information system
with a high degree of precision and
reliability needed for accounting purposes
Enable companies to use data as part of
strategic planning and tactical execution
(detailed steps to get to plan)
Often have subsystems called decision
support systems (DSS) and executive
information systems (EIS)
Typically have three main subsystems:
•
•
Provide predefined reports that support
business decisions
MIS reports may provide:
•
•
•
Feedback on daily operations
Financial
and
nonfinancial
information to support decision
making across functions
Both
internal
and
external
information
•
Transaction
Processing
Systems
(TPS): convert economic events into
financial
transactions
(daily
transactions)
Financial Reporting Systems (FRS) or
General Ledger Systems (GLS):
aggregate daily financial information
for infrequent events to enable timely
reporting
Management
Reporting
Systems
(MRS): used to solve day-to-day
business
problems,
such
as
budgeting or variance analysis
Objectives of an AIS
The three subsystems of an AIS collectively
achieve the following five objectives:
Decision Support Systems (DSS)
An extension of an MIS that provides
interactive tools to support day-to-day
decision making, widely used in the
organization
May provide specialized data or information
specific to a given situation
Facilitate the preparation of forecasts
1. Record valid transactions.
2. Properly classify those transactions.
3. Record the transactions at their
correct value.
4. Record the transactions in the correct
accounting period.
5. Properly present transactions in the
financial statements.
Allow modeling of various aspects of a
decision
Sequence of Events in an AIS
Executive Information Systems (EIS)
An AIS processes transactions in the
following order:
Provide senior executives immediate access
to internal and external information for
strategic decision making, narrowly used
Consolidate
information
internal
and
1.
2.
external
Provide reports in a summarized format for
executives
3.
Enter transaction data from source
documents into the AIS.
File original source documents, if
they exist.
Record
transactions
in
the
appropriate journal.
4.
5.
6.
7.
Post transactions to the general and
subsidiary ledgers.
Prepare the trial balance.
Enter adjustments, accruals, and
corrections.
Generate financial reports.
AIS Audit Trail
Expenditure and Cash Disbursement Cycle
•
•
•
Allows a user to trace a transaction from
source documents to the ledger and to
trace from the ledger back to source
documents.
•
•
•
•
Accounting Information System Cycles
Revenue to Cash Receipt Cycle
•
•
•
•
•
•
•
•
Allows real-time access to the
inventory ledger
Automatically approves or denies
credit
Concurrently records sales invoices,
transmits inventory orders, and
digitally sends packing slips
Has a terminal for the shipping
department
to
digitally
input
shipping notices upon shipment
Has a terminal for the cash receipts
clerk to record remittances
Closes sales invoices and posts to the
general ledger
Updates the customer's payment
record
Distributes management reports
•
•
Verifies requested purchases and
displays approved vendors for
competitive bidding
Digitally prepares the purchase order
(PO) and delivers the PO to the vendor
Has a terminal for the receiving
department to update receiving
report file, reconcile quantities
received, and close the PO • Updates
the inventory and general ledger
accounts
Has a terminal for the accounts
payable clerk to enter invoices
Links invoices to PO records and
receiving reports
Creates a digital accounts payable
voucher
Automatically approves payment of
invoices and sets the payment date
according to the invoice terms
Prints and distributes signed checks
Records payments, closes the vendor
invoice, and distributes transaction
reports to users
Production Cycle
Facilitates real-time monitoring of raw
materials inventory, production schedule,
and work orders
Generates work orders based on customer
demand and material availability, enabling
efficient coordination between departments
Actively manages inventory, including
tracking the flow of raw materials through
the production stages:
•
•
•
Recording the usage of materials,
labor hours, and overhead costs
Minimizing excess inventory
Managing finished goods inventory
Updates inventory records, job cost
accounts, and general ledger accounts in
real time
Integrates with financial institutions to
facilitate loan applications, approvals, and
disbursements
Facilitates
coordination
of
shipping
activities
by
generating
shipping
instructions,
managing
shipping
documentation, and interfacing with
logistics and transportation systems
Records the issuance and repurchase of
company stock, ensuring accurate tracking
of ownership changes
Produces reports such as production
summaries, work-in-progress reports, and
variance analyses to aid management
decision making
Human Resources and Payroll Cycle
Integrated with the human resource
management system (HRMS) for real-time
changes
Allows employees to enter timekeeping
data in real time
Allocates labor costs and calculates payroll
Updates employee records and produces
payroll registers
Creates digital journal entries
Attaches the original documents to the
entries
Automatically updates the general ledger
Fixed
Asset
(Property,
Equipment) Cycle
Plant,
and
Has a terminal for fixed asset groups to
create records in the asset subsidiary ledger
that include each asset's
•
•
•
Useful life
Salvage value
Depreciation
location
methodology
and
Automatically updates the general ledger
Prepares journal entries and creates a
depreciation schedule
Automatically
calculates
depreciation,
accumulated depreciation, and book value
at the end of the period
Calculates gains or losses for asset
disposals and related journal entries
General Ledger and Reporting System
Financing Cycle
Assists in financial planning by providing
data on cash flows, budget variances, and
financial projections
Manages financial transactions related to
obtaining and servicing debt, as well as
handling equity transactions
Ensures
compliance
regulations
Provides analytics and insights on financial
ratios, profitability, and other key metrics
with
financial
Acts as a central repository for financial
transactions, systematically recording and
organizing data into the general ledger •
Creates audit trails to ensure data integrity
Supports the creation and maintenance of
chart of accounts, ensuring accurate
categorization of financial transactions
Facilitates real-time posting of journal
entries
Automates the consolidation of financial
data
from
various
departments,
streamlining the reporting process
Generates comprehensive financial reports,
including
balance
sheets,
income
statements, and cash flow statements
Allows for customizable reports to meet
specific
reporting
requirements
or
regulatory standards
Enterprise Resource Planning Systems
(ERP)
Cross-functional enterprise system that
integrates
and
automates
business
processes and systems that must work
together
Have multiple modules that can function
independently or be integrated
Information can be shared among all
departments
Advantages and Disadvantages of ERP
Advantages
•
•
•
•
•
Costly implementation and ongoing
maintenance
Complex
May be difficult to configure
Enterprise
(EPM)
Performance
Management
Also known as business performance
management
(BPM)
or
corporate
performance management (CPM) systems
Software solutions designed to
executives make strategic decisions
Useful in breaking down high-level business
strategies
Key performance indicators
assigned to monitor progress
(KPI)
are
BPM Framework
The BPM framework is a five-component
model:
Environment: the arena in which the
company operates, defined by its industry,
competitors,
regulators,
consumers,
suppliers, and economy
Systems
and
Technology:
the
infrastructure, supplies, tools, and other
resources employed to ensure that the
business can meet its objectives
Processes: focuses on how an organization
uses its systems, technology, and people to
accomplish tasks that help it reach its
business objective
Organizational Culture: refers to the social
environment within an organization that is
driven by its mission, vision, and values set
by senior management
Single database
Integrated system
Faster business processes
Disadvantages
•
Enable leaders to plan, budget, and forecast
business performance
help
People: the primary drivers of activity in an
organization and the most valuable
resource; they support and cultivate the
other components in this framework
The BPM Spiral
Each of the five components of the BPM
framework can be broken down, studied,
and refined by engaging in four steps
explained in the BPM spiral:
Human
•
•
Database administrators
End users
Database Structure Overview Relational
Database
Structures data so that sections can be
stored separately
Database Management Systems (DBM)
Software that simplifies the creation,
access, manipulation, and management of
databases
Allows users to turn raw data into usable
information
Raw data consists of inputs that are
unprocessed whereas usable information
provides value by revealing patterns and
enabling forecasts
Database
A database is a shared, integrated
computer structure that has three technical
components and two human components.
Technical
•
•
•
Metadata: data about data including
its characteristics
Data Repository: the structure in
which data is stored, which is
governed by metadata
DBMS: a collection of programs to
manage the data structure
Tables within the database
relationally intact with each other
remain
Each table has a primary key, which is a
unique record that can be tied to another
table.
Attributes are other fields within a table
that can be unique or duplicates that
describe characteristics of the primary key.
Tables can have a foreign key, which can
have duplicates.
Data Warehouse and Data Warehouse
and Data Mart
Data warehouses store data in a format
designed to provide subject-oriented or
business-unit-focused
information
for
decision support
Data is often uploaded from operational
systems
Data analysis is
transaction system
separate
from
the
Data marts are smaller portions of a data
warehouse
Can be used by different parts of the
organization for specific needs
Data warehousing is a process that involves
several steps:
Extract
Data:
from
ERP
systems,
applications on smartphones and laptops,
and hard copy (paper)
Cleanse
Extracted
Data:
remove
redundancy and ensure data format
consistency
Normalize Data for the Data Warehouse:
ensure imported data characteristics are
aligned with existing data items
Transform Data Into the Warehouse Model:
establish key relationships across tables
and reconcile data names between systems
Load Data Into the Data Warehouse
Database: ensure data is fully loaded and
address any errors
Test Updated Data Mart: perform checks on
the data mart against the source systems
Below is a diagram that shows how raw
data is aggregated and stored in the
warehouse and further organized into a
data mart for us
1F. Data Governance
Data Management and Data Governance
Architecture: appropriately designed job
roles and IT applications
Data Management
Refers to the practices, tools, and systems
used to capture, transform, store, report,
and purge data
Includes:
•
•
•
•
Keeping data secure
Maintaining privacy
Complying
with
regulatory
requirements
Administering
effective
data
governance
Data management functions
summarized as follows:
Availability: information is available at the
right time
can
be
Governance: Data governance includes
mechanisms in place for organizations to
control, protect, and manage data
Life Cycle: Covers the processes for data
capture,
maintenance,
synthesis,
transformation,
analytics,
usage,
publication, archival, and purging
Architecture: Systems and applications that
store data. Includes databases, data lakes,
and data warehouses
Security and Privacy: Keeping data secure
using techniques such as data masking and
encryption
Visualization and Reporting: Methods data
is distributed, communicated, and accessed
by users
Data Governance
Focuses on the effective management of
data availability, integrity, usability, and
security
Strong data governance models have the
following components:
Metadata: data describing other data
Policy: to help companies
governance into practice
translate
Quality: data integrity to ensure there are
no anomalies
Regulatory
Compliance
and
Privacy:
ensures
employee
and
consumer
information are protected
Security: data is securely preserved, stored,
and transmitted
Data Governance Frameworks: COSO
Internal Control Integrated Framework
Data Governance Frameworks: COSO
Internal Control—Integrated Framework
The COSO Internal Control—Integrated
Framework includes two categories with
principles that pertain to internal control
over information technology.
Control Activities (Principle 11): There
should be controls over technology in order
to achieve organizational objectives
Information and Communication (Principle
13): Organizations should acquire, create,
and use quality information in order to
support internal controls
Information and Communication (Principle
14):
Effective
communication
of
information is necessary to support internal
controls
Data Life Cycle
Policies regarding data quality should
address data across each of the eight
stages within the data life cycle.
•
•
Segment groups of customers into
categories for targeted advertising
Evaluate fluctuations in costs and the
variables driving costs
Data Consolidation
Aggregating data into a single collection or
file for further processing
Data Capture
Data Cleansing
Stage at which data is extracted, created,
received, or procured
Actively Captured: user consent is given
Passively Captured: no user consent
Technologically
machines
Captured:
captured
by
Personally Captured: collected by another
person in real time
Involves
deduplication,
removal
of
inaccurate data, outliers, and missing data
fields
Involves validating data with its original
point of capture
Data Transformation
Data Maintenance
Taking data in its raw but clean form and
converting it into information that gives
more insight and meaning
Initial processing, moving, and preparing
for synthesis or further processing [extracttransfer-load (ETL) process]
Achieved
through
appending
more
information,
applying
mathematical
models, or visualizing the data
Occurs before any value can be extracted
from the data
Data Reduction
Periodic audits should be performed to
ensure integrity
Frequent backups should occur
Data Synthesis
Modification and enhancement of data
through preprocessing, consolidation, and
transformation
Synthesized data can be used to:
•
•
•
•
Predict consumer buying patterns
Estimate sales figures for the coming
quarter
Forecast consumer saving patterns
Understand relationships between
products
Process of eliminating variables by looking
at each variable's individual value
Sometimes referred to as compression or
dimension reduction
Reduction can also be performed on data
models, such as predictive models used for
forecasting, that contain multiple variables
The following tests can be used to help
determine which variables should be
reduced or eliminated:
Look for variables with too much precision;
if more precision than is relevant for the
analysis it may be recoded.
Search for repetitive data capture; if the
capture (hourly, daily, weekly, etc.) contains
80 percent identical data for each
repetition, then the identical data can be
removed from each capture and referenced,
while the 20 percent changing data is
retained in place.
Variables missing from too many records
should be excluded, as should records with
too many missing variables
Incomplete variable sets can affect the
accuracy of a model, potentially making it
seem as if certain variables are predictive in
nature when they are not
Backward variable elimination starts by
including all variables in an equation,
separately testing the impact of removing
each variable
Variables that do not contribute to the fit of
the regression equation are deleted; this
process is repeated until the model's
minimum acceptable performance is
reached.
Forward variable selection adds one
variable at a time using the variable that has
the next highest incremental change in
performance
May be more efficient in terms of time and
required computing power as compared to
backward variable elimination because only
new variables with positive incremental
value are included in the model.
Data Usage
Stage when data benefits the organization
in some way by supporting employees or
consumers
Data Publication
Point that data is made known to internal
and/or external users
Data Archival
Phase that stores data in a way that
maintains speed of access and minimizes
bottlenecks
It may take extended time to gain access to
archived or restricted data
A balance between time to access, and data
accuracy should be considered
Data Purging
Last phase of the data life cycle
Data is removed that no longer has any
organizational value or legal use
Archiving and Record Retention
Data is archived for organizational access
and for regulatory requirements
Companies should have a record retention
and management policy
Records should be kept of data's current
form and expected deletion date
Data Analytics
Organizational Retention Needs
Point at which questions can be answered,
such as:
Retention requirements should focus on
records that track performance, such as
financial statements, performance reports,
or forecasts
•
•
•
Finding the relationship between
targeted advertisements and sales
Estimating projections of future
sales and cost of sales
Profiling consumers or projecting
product performance
These records help monitor and improve
operational performance, and so are
retained in accessible states
Other records are kept in order to supply
the company with defense material from
regulation or prosecution
Regulatory Considerations
Regulatory agencies with record retention
requirements include:
•
•
•
Internal Revenue Service
U.S. Department of Labor
U.S.
Securities
and
Exchange
Commission (for public companies)
State health departments and local
governmental entities
protection of information technology assets
from outside threats or attacks.
NIST Cybersecurity Framework
Voluntary framework introduced by the U.S.
Department of Commerce
Consists of six areas of focus, which are
further subdivided into:
Categories: tie outcomes to
activities and company needs
specific
Subcategories: divide categories
management and technical activities
into
These entities may request records related
to:
Informative References: method to achieve
subcategory outcomes
Financial
reporting,
payroll,
timekeeping,
and
disciplinary
documentation
Occupational safety and health logs,
property deeds, permits, licenses,
and insurance policies
NIST Cybersecurity Framework: Six Areas of
Focus
•
•
Retention requirements vary by state and
industry
Archival Procedures
Data retention policies should include
appropriate data backups.
Example metrics of success:
•
•
•
•
•
Number of failures of data backups
or archive transmissions
Number of successful backups
Percent of successful fulfillments of
legal and regulatory requests
Number of violations by regulatory
agency
Cost of penalties and fines
Information Technology Protection and
Security
Cybersecurity policies are a part of data
governance models that focus on the
Govern: establishes, communicates, and
monitors the organization's cybersecurity
risk management strategy
Identify: develop an understanding
personnel, systems, and processes
of
Protect: deploy safeguards and access
controls
Detect: administer tools to identify attacks
and high-risk employee behavior
Respond: counter threats and continuously
improve as risks evolve
Recover: contain cybersecurity
mitigate losses, and restore
operations
events,
normal
Security Controls
Access Controls
Vulnerability Testing: proactive tactics to
monitor for known vulnerabilities
Physical and/or virtual security tool used to
restrict access to company resources or
company information
Penetration Testing: or "pen" testing, is an
active attempt by an organization to hack a
company's network to find weaknesses
Biometrics: the use of an individual's
physical attributes to securely access
protected information
Multifactor Authentication: use of a
secondary device or application to validate
one's identity to access another device or
account
Physical restriction of access can involve the
use of badges or key fobs preventing
unauthorized entrance
Types of access controls:
Role-Based:
give
employees
according to their job role
access
Firewallss
Attribute-Based: also referred to as policybased controls, these grant access to data
and systems based on a policy or set of
conditions (such as the time of day)
Software applications or hardware devices
that protect network traffic by filtering it
through security protocols
Discretionary: give access at the discretion
of a system owner or administrator based
on a company's needs
Basic packet-filtering mechanisms that
analyze network traffic to accept or deny
the data
Mandatory: grant access through a
clearance process managed by a central
authority; are common in government, the
military, or health care organizations
Other types of firewalls include:
Circuit-Level Gateways: control traffic by
verifying the source of a packet
Stateful Multilayer Inspection Firewalls:
combine packet-filtering and network
address translation to control traffic
Network Address Translation Firewalls:
assign an internal network address to
specific, approved external sources so that
those sources are approved to be inside the
firewall
Next-Generation (Advanced) Firewalls: can
assign different firewall rules to different
applications as well as users, giving lowthreat applications more permissions and
high-security applications more restrictive
rules
1F. Technology-Enabled Finance
Transformation
System Development Life Cycle (SDLC)
A framework that organizes tasks at each
phase of development and use of a
business process
There are two strategies for managing the
SDLC in general use today:
•
•
Waterfall model, also called the
traditional method
Agile development, which evolved
from the waterfall model
The Waterfall Model
•
Benefits of the new system Waterfall
Model
The number and names of phases in the
model differ between companies, but they
all contain the same general process:
1. Plan: Management evaluates the
business needs of the system and whether
to accept the project.
2. Analyze: Management defines key
business problems and steps to address
them.are not realized until complete
There is no customer input and change is
difficult to manage
Some employees may be idle before or
after their SDLC step
Feasibility studies are conducted to
determine whether the project is adhering
to the original plan
Studies begin with the Analyze stage and
continue for each subsequent stage
Feasibility studies may incorporate multiple
elements, including:
Has distinct steps involving separate
groups or teams of employees
Each team performs a functional
specialization in a sequence
Agreements are created to describe each
step and their sequence
The project passes to the next team when
the prior team ends its work
The following are some challenges
associated with the waterfall model:
•
Requires a great deal of time to
complete
•
•
•
•
•
Economic feasibility
Technical feasibility
Operational feasibility
Scheduling feasibility
Legal feasibility
3. Design: The technical implementation
plan is created while business requirements
are translated into technical design
documents.
Individual technologies are evaluated and
selected.
The design phase i divided into three parts:
1. Conceptual Design: broad translation of
business requirements into technical
requirements
2. Logical Design: hardware and software
specification
3. Physical Design: more granular platform
and product specification
4. Develop: The technical implementation
and conversion plan is executed.
Buildings and rooms are prepared,
hardware procured, and programmers
create proprietary software.
The new system is completely built, with
most of the project budget spent.
Changes to the plan become more
expensive since each step builds on the
prior step.
5. Test: The system is checked for
adherence to the business requirements.
customers, deploying to a subset of users
after successful deployment (average cost,
average risk).
Blue/Green (or Other Pair of Colors), or
Shadow: The new system is fully deployed
in parallel with the old system, deactivating
the old system once the new system is
handling all the traffic.
7. Maintain: Ongoing adjustments and
improvements occur at this stage.
Begins as soon as deployment is complete.
Adaptations are made to the product to
keep it optimized.
The system is evaluated as it ages,
repeating the SDLC when appropriate.
The Agile Framework
The new product is evaluated for proper
functioning.
Backward-looking testing is conducted,
which tests against initial requirements.
Forward-looking testing is conducted to see
how well employees and customers can
perform tasks.
6. Deploy: The new system is delivered to
end users, with the following methods
available for deployment:
Plunge or Big Bang: The entire new system
is immediately delivered to all customers
and clients (lowest cost, highest risk).
Ramped (Rolling, Phased) Conversion:
Portions of the new system replace
corresponding parts of the old system, one
piece at a time (above-average cost, belowaverage risk).
A/B Testing (Pilot, Canary): Subset of users
gets the new system while the old system is
still in use and assigned to current and new
Created to address issues with the waterfall
model
Characterized by cross-functional teams
Teams are dedicated to particular functions
Frequent meetings
features kept small
are
required,
and
Team sprints, usually lasting two weeks,
address changes
The Agile process can be characterized
using the steps as shown in the graphic.
Uses situational data to automate decisionmaking processes
Classifies data based on results of earlier
decisions through comparison to similar
situations
Core Values
Although the items on the left are valuable,
Agile promotes the items on the right.
Agile Principles
•
•
•
•
•
Satisfy the customer with early and
continuous delivery of the highestpriority features.
Welcome change: A change request is
an opportunity to be closer to the
customer needs.
Deliver working software frequently;
working software is the primary
measure of progress.
Complete only the work requested by
the customer.
Conduct short, frequent, and regular
meetings to maintain focus and make
adjustments.
Artificial Intelligence
AI, machine learning, and deep learning are
three
similar
terms,
often
used
interchangeably, for computer programs
and
algorithms
built
to
simulate
characteristics of human logic and
intelligence.
Focuses on processing large quantities of
data and learning from trends • Uses
insight to automate decision-making
processes
Inference Engines
Additional data sets with correct answers
(called training data) are used to improve
predictive power • Credit card companies
and banks invest heavily in inference
engines
Business Process Analysis
The automation of business processes
using computer programs designed to
perform repetitive tasks
Allows the company to deploy human
resources to tasks better suited to human
skills
Examines an existing business process to
describe the steps taken, the exchange of
information, the governance of policies for
each transaction, and the knowledge
needed to complete each task
Done to improve the efficiency of
operations or to understand the process
thoroughly enough to replace it
Robotic Process Automation (RPA)
Programs that can extract data from user
interfaces to initiate further processing
based on the data extracted
A refinement of general Web scraping tools
that scour the Web looking for instances of
specified text to collect all material
surrounding it
May concern employees who carry out
repetitive tasks, but can make data more
accessible, shifting labor to more refined
skills
Natural
Language
Software)
Processing
(NLP
Data processing can be performed more
efficiently from a single location
Interprets human languages so that
technology can perform tasks or interact
with humans
IT hardware support may be reduced
throughout the company
Requires the mapping of pragmatics,
syntax, phonetics, pitch, and tone
Necessary to build a network embedded in
household devices or other Internet of
Things (IoT) devices
Neural Networks
Modeled after neurons that facilitate the
function of human or animal memory
Consists of an input layer, hidden layer, and
an output (results) layer
Weights may initially be predetermined but
the intent of the neural network is to learn
from prior trends
Just as a human's response changes, its
reaction is refined, which yields a different
outcome
The computing architecture needed to
make fuzzy logic decisions for inference
engines, used in fraud detection
Cloud Computing
Renting storage space, processing power,
proprietary software, or all three, on remote
servers from another company
When a company buys infrastructure as
opposed to renting it, the company must
purchase enough to cover peak usage
Software as a Service (SaaS)
A business model in which a company
delivers
subscription-based
software
services through licensing or service
delivery
Follows the idea that software is no longer
thought of as a static product to be
purchased, delivered, used, and replaced
No requirement for ongoing costs of
support and innovation in response to
changes to the business environment
Internally developed software incurs
continued development costs in the form of
IT employees
When software is purchased from an
outside source, costs include the upfront
cost of the software as well as the cost to:
•
•
•
Maintain the software
Update it
Troubleshoot problems, adding to
the cost of owning it
Formalizes the ongoing costs of software
maintenance to users by changing the price
of the software from a one-time outlay into
an ongoing subscription
Software as a Service (SaaS)
Advantages of SaaS
During low-volume periods, this costly
infrastructure is idle
The user company enjoys continuously
supported and updated software, reducing
the need for on-site equipment.
Excess infrastructure capacity can be leased
for off-peak times or used for purpose-built
infrastructure to assist customers
Space needed
reduced.
to
house
hardware
is
Customers have access to a support team.
Access to SaaS products is usually greater
than those purchased or internally
supported.
Disadvantages of SaaS
Companies have less flexibility in managing
the software and labor is needed to modify
other applications
Companies are no longer able to stretch
licenses beyond their recommended life,
potentially increasing IT costs
While many SaaS providers allow companies
to tailor their software, there could be a lack
of customization.
Blockchain
A control system originally designed to
govern the creation and distribution of the
digital currency Bitcoin
Also called a cryptocurrency, Bitcoin must
be "mined" in order to confirm transactions.
Mining involves a person or group of people
performing cryptography to validate or
confirm blocks of transactions.
The reward for solving (validating) the
equation is both the receipt of Bitcoin and
the validation of a new block.
Developed to prevent Bitcoin from being
replicated and to limit its initial creation
Resistant to alteration, contains multiparty
transaction
validation,
and
has
a
decentralized nature
Alteration is difficult because each block
adds to all prior blocks, enabling everyone
to view all blocks in the chain
Because the history of prior blocks can be
viewed, this serves as a form of audit trail.
Blockchain Terminology
Peer Network: all devices participating in
the blockchain
Distributed Ledger: a peer network with
shared ledgers
User: blockchain users or participants in
processing
Hash Code: an encoded record with date,
time, and keys
Block: an encoded record of one transaction
Blockchain: a string of blocks showing all
transactions
Public Key: A person/company/entity who
intends to spend or receive cryptocurrency
or other data on a blockchain network
Private Key: A password to access a
blockchain account
Fork: A divergence of the blockchain,
changing trajectory
Smart Contracts: agreements as opposed to
currency transactions, validated by a
blockchain
Mining: the
transactions
validation
of
blockchain
Blockchain Process
A chain of data blocks is attached to every
Bitcoin
Each block contains a hash code, or digital
fingerprint, for each transaction as well as
all preceding hash codes
Altering a transaction will alter the hash
codes, making that hash code out of sync
with the other blocks in the chain
Blockchain uses a distributed ledger, rather
than a single ledger, making alterations
difficult due to transparency
All blockchain participants would have to
validate a false alteration in a transaction
When a person holding digital currency
wishes to make a payment, a new
transaction is requested
The user's computer stores the blockchain
for the involved transaction, which is
compared to other ledger copies.
Any discrepancies in hash codes may
constitute evidence of tampering, causing
the transaction to be refused.
The user's version of the blockchain is then
resynchronized to match the peer network's
version.
Blockchain Applications
Blockchain is a powerful but complex
technology that may create problems with
existing applications and security practices,
so its limitations should be considered
when adapting it to new applications.
The
complicated
math
processing
mechanism for creating new blocks
includes the public key of the receiver and
the private key of the giver.
This means that blockchain still depends on
a password to authenticate. Human beings
are bad at password security, and many
companies are bad at cybersecurity.
If these concerns can be managed, there are
beneficial applications to the wide adoption
of
cryptocurrencies
and
blockchain
technology.
Can be used to make transactions more
transparent and secure, even between
parties without compatible banking or even
legal systems
Can help developing nations, which do not
have the same financial infrastructure as
developed nations, join the marketplace
Unfortunately, blockchain technology also
aids criminals and terrorists to circumvent
international laws and sanctions
Blockchain can also be used to create smart
contracts, where the terms can be agreed
on, executed, and verified automatically
Can serve as a function similar to notaries,
lawyers, and the courts in contract law
recording when a service is complete, when
payment is due, and when it has been
received
If both the service and the payment can be
observed by the blockchain peer network,
then payment can be automated, removing
the need for an intermediary to officiate it
The distributed ledger of blockchain is
similar in architecture to nonrelational
databases, which enable faster access to a
database by multiple, widely dispersed
users
Could serve as backup data stored outside
the database (therefore not slowing it
down)
Could represent a means to increase the
speed of nonrelational databases by
increasing the ability to roll back invalid
changes after beginning them
Could promote the integrity of relational
databases
1F. Data Analytics: Part 1
Business Intelligence
BI is the aggregation and transformation of
data into visualizations and presentations
to make business decisions.
Transactional databases are used in BI and
feed into data warehouses used for
optimized searching.
Business analysts use data warehouses to
search for patterns, regional trends, or
other business insights.
The business analysts' toolbox starts with
basic database tools, including (SQL)
applications, Microsoft Excel®, or other
similar analytic applications used to
transform the data.
Transformed
data
is
presented
in
visualization software such as Power BI® or
Tableau® so that business insights can be
quickly and effectively communicated to
management.
Variety: indicates that there are multiple
formats in which data can be stored
Prior to the era of Big Data, the most
common formats were organized text files
(documents) and number-based files
(spreadsheets).
Advances in technology have increased the
capacity to process large files quickly,
increasing the variation in formats.
Images were historically difficult to
manage, but now can be algorithmically
analyzed with today's computing.
Veracity: refers to
reliability of data
the
accuracy
and
Requires cleansing and maintenance, which
means gathering data can be slow and
expensive.
In addition to companies gathering their
own data, it is now common practice to
purchase large streams of data from thirdparty sources.
Big Data
Opportunities and Challenges With Big Data
The term coined in the mid-2000s refers to
expanded electronic storage capacity and
manipulation of large data sets
Opportunities
Involves running advanced calculations on
millions of records
Used to predict trends or solve complex
business problems
•
•
•
The Four Vs
Volume: the amount of data measured in
bytes, which contain enough binary space
to store one letter of text
Velocity refers to:
The speed of data transmissions
How quickly the data can be processed
Can increase the efficiency of
business and society as a whole
Helps identify common traits among
customers and more accurately
target prospects with relevant
advertisements
Provides more information about
what, where, when, and how, which
enables better management for
supply chains
Challenges
•
Companies
know
more
about
consumers, which causes concern
among privacy advocates
•
•
Channels must be created within an
organization to protect information
from theft and misuse
Information must be restructured so
that the origin of sensitive materials
is masked and cannot lead to specific
individuals
Data Structure
Big Data is typically classified into three
classifications:
Structured Data: the oldest classification
of data
•
•
•
•
Has an explicit organizational pattern
May have segments of fixed length
where each segment contains a piece
of data
May be segments of variable lengths
where each segment contains a piece
of data and a header
An example is a relational database
where each database table has a
header that identifies the structure of
rows that belong to it, regardless of
where the rows are stored in memory
Unstructured Data: lacks any kind of
organizational structure
•
•
A written novel would be an example;
although a novel has chapters and
pages, these do not define lengths or
content.
Other examples include images
(including .pdf files), audio files, or
social media text files, such as
reviews and posts.
Semi-Structured Data: data that does not
have an organizational structure that
defines lengths and content but contains
elements that can provide some degree of
identification
•
•
•
Comma-delimited files are one of the
oldest types of semi-structured data.
This kind of file has different data
types in sequence, separated by a
comma, so the length of each field is
not known but the order of fields is
known.
The programming language
Data Progression
The value of information can be charted on
a continuum, starting with raw data that is
an unconnected fact
Data becomes information when it conveys
meaning and purpose, usually requiring
connected data to provide context
Example: An individual sales transaction
has more value when it is connected to
other pieces of data, such as the date of the
sale and the customer's information
Managing Data Analytics
Presents businesses opportunity to operate
with increased efficiency and effectiveness
All employees can make better decisions
about their work if they have timely access
to accurate, pertinent information
Can be expensive due to computing
infrastructure and the need for skilled
employees to run it
Managers who are unfamiliar with it may be
hesitant to fully use analytics
If used inappropriately, or if the results are
misinterpreted, then decisions can be even
worse than decisions made without data
Data Mining
The process of investigating large data sets
to discover previously unknown patterns
Combines the aggregation and analysis of
data by trainable artificial intelligence (AI)
and machine-learning-enhanced decision
support systems
Requires the decision support system and
the AI to be trained with data similar to the
real data the AI is expected to investigate
Training a model helps it to understand
how to interpret certain types of
information and yield meaningful results
The parameters of the model have a large
impact on what patterns are judged to exist
Many data-mining techniques require an
initial seed (or guess) value to begin the
analysis
For example, cluster analysis software often
requires the analyst to define the number of
clusters before the data-mining process
begins
Exploratory Data Analysis
•
•
•
•
•
Also
called
data
mining,
or
"atheoretical" research
Used to investigate existing data sets
for useful patterns
Unlike traditional research, the data
is not used to show support for a
preexisting
theory
or
desired
analytical outcome
Atheoretical analysis is applicable
when
the
target
population
resembles the sample, yielding high
validity
Cluster analysis or decision trees are
examples of exploratory analysis
Challenges of Data Mining
Quality and Quantity of Data Required: A
large quantity of data is needed to produce
valid results from the data that can reliably
be used for decision making.
Small quantities of bad data can
dramatically skew the results of data
mining
There may be significant outliers, or bias in
the data collection process
Every batch includes bad data, so a
defensible method for dealing with bad
data must be developed
Timeliness: Data gathering and data
cleaning are expensive and time-consuming
activities.
A company with a small or inexperienced
data science team can spend too long
gathering and cleaning a data set for
optimal decision making
Data science departments must have the
scale and skill to process data quickly
Expensive Employees: Highly skilled
professionals with advanced programming
and technical knowledge are required to
work with file sizes and software packages
today.
Although software processes can be run
without statistics expertise, only an expert
can be certain that the results are valid or
reliable
Corporate Culture: Executives are often
educated, trained, and acclimatized to trust
their own judgment and that of their peers.
It can be a challenge to devote enough
resources for a department to competently
perform data mining
Even if data mining has been done, it can be
a challenge for executives to understand
and apply the insights
Retrieving Information
To perform data mining or even more
everyday business tasks, analysts must first
retrieve the data before they can analyze it.
For example, many businesses have a
customer table in their database that
contains records such as the customer's
name and address
The products a company sells would be
another category of data
These tables are separate and do not
duplicate information
Every row in a table needs to have a unique
identifier called a primary key, so the row
can easily be found
When information from another table needs
to be referenced, the primary key of the row
from the other table is included as a data
item in the original table and is called a
foreign key
Retrieving Information
Query Tools: structured query language
(SQL)
The programming language specifically
designed to selectively retrieve (and load)
information that has been stored in
relational databases
Invented in 1970 and was patterned on
English sentences
One of the most commonly used commands
is SELECT, which is used to retrieve data
While query tools and languages exist for
various types of information retrieval, most
of those languages are rooted in SQL in
some form
Introduction to Analytic Data Modeling
One of the simpler forms of analytic
modeling in data mining is a decision tree.
Based on a series of decision points called
nodes, decision trees are decision support
tools that provide outcomes based on
probability or fact.
They begin with a single node, or question,
with at least two possibilities.
Each possibility is assigned an outcome
(e.g., yes or no; A, B, C) or probability that
breaks off further into additional outcomes.
These outcomes have their own nodes and
outcomes, continuing until all possibilities
have been exhausted, with the end result
resembling a tree.
The parameters in the decision tree's
algorithm can be adjusted based on the
unique characteristics of a given data set or
circumstances.
Data Mining Process
To begin, a substantial data set must be
gathered that records the various qualities
being discussed. • Often, data sets consist
of many events, each of which has a binary
choice such as:
Fraud transaction vs. legitimate transaction
Customer gives favorable rating vs.
customer gives unfavorable rating
Customer purchases product vs. customer
does not purchase
The purpose of data mining is to identify
patterns among the data that will explain
the binary choice.
Making the First Decision
The algorithm will choose where to draw a
vertical (or horizontal) line so that the ratio
between the choices on each side of the line
is as high as possible.
The data collected may not appear to have
a pattern or be easy to collect.
Using advanced algorithms helps draw
insights on an otherwise uneventful data
set.
It is important to calculate all possible
ratios to complete each mining step.
Growth of Decision Trees in Data Analytics
Decision tree algorithms could continue to
expand into perpetuity and further
subdivide the diagram.
Further divisions create smaller boxes that
are more exclusively the same color and
further build the decision tree.
Growing the Decision Tree
This practice reaches a point of diminishing
(even negative) returns.
Once the first iteration is complete, the
process is refined and repeated. Rules for
subsequent decisions are generated by the
same ratio-driven algorithmic criteria used
for the first decision.
The better a model fits the data from which
it was constructed, the less reliable it will be
when applied to other data, such as real
customers in the real world.
This is because the model will not be able
to accommodate or interpret variation from
new observations
The inability to accommodate can be
mitigated by testing the model against a
separate data set (testing data)
Testing determines how large the algorithm
should grow on the decision tree, and helps
choose
between
different
candidate
decision trees
Growth of Decision Trees in Data Analytics
A multidimensional model uses the same
logic as a two-dimensional model, but more
than two would be difficult.
The algorithm does not have to use straight
lines or planes to divide spaces.
Complex curved multivariate shapes can be
used if the algorithm is sophisticated
enough and sufficient computing power is
available.
1F. Data Analytics: Part 2
4. Prescriptive: focuses on the business
relationships discovered by diagnostic
analytics to recommend actions
Types of Data Analytics
The differences between the types of data
analytics is in the intention of the analysis,
rather than the techniques used.
The person using the data may want to
simply describe what is happening or find
the cause behind what is happening
The user may also be more concerned with
predicting future trends instead of
describing past ones
The types of data analytics include:
1. Descriptive: answers questions to
discover what has happened by performing
some of the following tasks:
•
•
•
Data assembly and organization
tasks such as cataloging daily,
weekly, and monthly sales reports
Usage rates and expenditures for
advertisement
Inventory accumulation or depletion
Actions are intended to influence future
events
Focuses on what should change to bring
about different results
Prescriptive analytics are often undertaken
by experienced analysts at the managerial
or executive level
Types of Analytic Models: Clustering and
Classification
Types of Analytic Models
Each model has strengths and limitations
Some are basic in structure and less
complex in application
Some require statistical knowledge and a
team of analytic consultants to apply the
models to consumer data
Clustering
to
Used to determine whether a large group
contains two or more cohesive subgroups
Example: Diagnostic analytics may attempt
to discover associations between marketing
and sales, or between inventory and sales,
so that management may understand the
relationships between the occurring events.
Each subgroup's members are more similar
to members of their own subgroup than
they are to other subgroups
2. Diagnostic: answers questions
discover why events are happening
3. Predictive: brings together the data from
descriptive and diagnostic analytics to
predict expected future events
This is based on what is known about
current conditions and assumes that
relationships remain stable
Accounting analysts often use these tasks
to inform managers of anticipated gains
and expenses in future periods
Used to identify characteristics that unite or
separate the customer base
Used to target prospective consumers as
well as existing customers
Classification
Attempts to accurately label data points as
belonging to an established group
Binary classification is when there are two
options, and analysis is used to choose the
more likely of those two options
Example: In conversion prediction, data is
used to predict whether individual
customers are likely to purchase a product.
Data is gathered about known cases where
existing customers purchased products,
and data is gathered about many other
people to analyze which people most
resemble the existing customer base and
may
be
more
willing
to
make
a purchase.
Other types
include:
of
classification
analyses
Imbalanced classification techniques are
used to isolate anomalies in cases in which
one option is rarer than the other
Similar techniques are used to determine
outliers during the data-cleaning phase of
other analysis tasks
There are multiple independent variables
and multiple slopes.
Logistic Regression
Used for data that is either binary or
categorical in nature as opposed to
continuous
Useful for predicting outcomes with two
possibilities
Yes/No or True/False
Finite function ranging from 0 to 1, rather
than linear, which ranges from 0 to infinity
Because the range is between 0 and 1, the
probability of an occurrence can be
estimated
Predicted values closer to 1 are considered
more likely to be affirmative
Types of Analytic Models: Regression
Benefits of regression
Regression
Can make
decisions
An advanced mathematical analysis that
produces an equation to determine the
relationship between variables • Applied if
there is a suspected underlying linear
relationship between two or more variables
more
informed
business
By
using
business
conditions
as
independent variables, the output can be
predicted with statistically significant
results
Can also be applied in the event no previous
relationship is known
Improves the precision of business decision
making
Type of relationship that diagnostic
analytics is intended to discover
Limitations of regression
Multiple Regression
The equation has multiple independent
variables.
The key difference from simple regression
is that multiple regression assumes more
than one factor influences the dependent
variable.
There is only one intercept and one error
term.
Can only be generalized to populations that
resemble the sample
Making business decisions using the
incorrect use of this tool may lead to poor
business outcomes
The accuracy of regression is limited if the
sample size is small
Correlation Coefficient
Referred to as (r), measures how closely the
regression equation fits the data
β0, the intercept or value of the dependent
variable when the independent variable is 0
Range of–1to1
β1, the slope of the regression line
A correlation coefficient of –1 means the
dependent and independent variables have
a perfect negative linear relationship
These estimates are not perfectly accurate
unless the correlation coefficient is either –
1 or 1
A correlation coefficient of 1 means the
variables have a perfect positive linear
relationship
A confidence interval for β0 or β1 is the
probability that the actual parameter values
fall between two set values
Coefficient of Determination (Goodness
of Fit)
P-value: a statistical measure that indicates
the significance of the relationship between
the independent and dependent variables
Also called R-squared, this measures the
ability of a model to explain the outcome
(the Y values or dependent variables) given
the X values or independent variables used
in the regression model
Measures the goodness of fit of the
regression line; calculated by squaring the
coefficient of correlation (r)
The coefficient of determination varies
between zero and 1 and is read as a
percentage
Standard Error of the Estimate: a measure
of the accuracy of the relationship
predicted by the regression analysis
Low p-value (< 0.05) suggests
relationship is statistically significant
High p-value (>
relationship may
significant
the
0.05) suggests the
not be statistically
Analysts use p-values in combination with
the coefficient estimates to assess the
significance and strength of the regression
model
Types of Analytic Models: Time Series
Analysis
Time Series Analysis
The standard deviation of all errors
between actual observations and the
predicted dependent value for those
independent values
Shows data collected over a period of time,
potentially revealing patterns over time
As the number of data points increases, the
standard error of the estimate becomes
smaller
Visualizing time data can be used to
separate trend lines, seasonality, and
cyclicality from irregular time patterns
Confidence Interval: a measure of the
degree of certainty when applying
statistical methods
A trend line is the line that best fits the data
across the time series
Simple linear
parameters:
regression
yields
two
Time is on the x-axis and the observed
values on the y-axis
This line is calculated using regression
analysis
The slope shows the average overall
direction of the observed values on the yaxis
Benefits
•
•
Pattern identification and forecasting
Separates trend lines, seasonality,
and cyclicality from irregular time
patterns
Limitations
•
•
•
Missing data (may impact results)
Assumptions of stationarity (assumes
that
the
underlying
statistical
properties remain constant over
time)
Complex models
Predictive Analytic Techniques
Predictive analytics generally fall into two
types: forecasting analytics and referential
analytics
1. Forecasting
Analytics:
predicts
future events based on past events,
past conditions, and expected future
conditions
Incorporates the effects of likely changes so
contingency-based recommendations can
be provided
2. Referential Analytics: predicts what
will happen to one group based on
known data about what happened to
another group
Seasonality: occurs when time series data
exhibits regular and predictable patterns
Used for near-term events so it is less
important to try to predict future conditions
Occurs at time intervals that are less than a
year
Challenges of Fitting Analytic Models to the
Data
Irregular patterns: refer to unpredictable
fluctuations that do not follow a distinct
trend, seasonality, or cyclicality
Only a fraction (from 10 percent to 30
percent) of the available data can be used
to build the model (called training data)
May arise due to unexpected events,
external influences, or random fluctuations
The remaining data is reserved for testing
Can be challenging to predict
Time Series Analysis
A model that perfectly fits the test data is
likely to be overfitted, meaning it explains
the test data so well that it is less effective
when used on other data
Cyclicality: occurs when time series data
rises and falls over periods of time that are
not fixed or predictable
It can be difficult to know when to stop
building the model
Generally, occurs over periods of more than
one year
Once several versions of the model have
been built and trained, those versions are
all run against the test data set
The model that performs best is selected,
unless the model can be improved
If it can be improved, the training and test
data sets may be shuffled back together,
and a new random subset is taken
The process would begin again after
modifications
Limitations of Data Analytics
There are three categories of data analytics
limitations:
Technical limitations imposed by the
computing hardware and software: The file
sizes for data sets and the amount of
computing memory necessary to run
analytics software are very large and very
expensive
Available human capital: Data scientists
have a highly specialized skill set; the
quality of data analytics depends on their
expert judgment
The data itself: Ongoing expense and effort
must be spent to continuously gather large
quantities of timely, relevant, high-quality
data
Other Analytic Methods
Sensitivity Analysis
Used to investigate how the results of an
analysis could change if adjustments are
made to inputs or independent variables
Most often used when the relationships
driving dependent variables are not
explicitly or reliably identified, but the
effects of the variables are quantified
Also called "what-if" analysis, the main
benefit is that it helps management identify
tipping points at which business conditions
may require management action or
intervention
Goal-seeking analysis
A subcategory of sensitivity analysis
focusing on achieving a particular set of
outputs
Inputs can be adjusted in several ways, such
as increasing sales incentives or changing
advertising dollars spent, to change
outcomes
Each change will have possible secondary
effects
Attempts to discover a formula in which the
examined inputs can be altered relative to
one another and arrive at the intended goal
Simulation Models
Risk-analysis tools that perform multiple
sensitivity analyses to find business
conditions resulting in the most extreme,
yet acceptable, business outcomes
Have the same main benefit (identifying
tipping points) and limitation (potential for
misidentification of tipping points) as
sensitivity analysis
Monte Carlo Technique: a type of
simulation model with both multiple
variables and multiple assumptions about
the distribution of the data
Runs many analyses at once
For each variable being studied, every
possible type of distribution is presumed
As the simulation processes data, highly
unlikely distribution types drop from the
analysis until the most likely outcomes
remain
Does not result in a single answer but gives
a range of likely results
Evaluating Data Visualization Options
Data Visualization
The pictorial or graphical representation of
information displayed to make trends and
key concepts visible
Traditional charts and graphs are now
applied to information on a larger scale,
and then enhanced with more nuanced
graphical adaptations
Benefits
Reduces time needed to communicate key
findings
and
highlights
otherwise
unnoticeable trends or statistics
Reveals subtle trends in an obvious way,
simplifies complex data, and identifies
patterns and relationships
Limitations
May lack the precision of the actual
underlying data
Can be limited by the viewer's ability to
understand the message conveyed by the
image
Determining
the
Best
Communicate Results
Channel
to
Data visualizations are made more effective
by isolating the key concept that needs to
be communicated and then determining the
visualization that best conveys the concept
For example, in a grouping of light-blue
dots, most humans can distinctly see a
single red dot located in the group
Likewise, for a series of bars of the same
height, a bar that is double the length of all
other bars stands out
Visuals can have numerical overlays that
supplement key findings with a percentage
or an index
One key in selecting the best visual is
understanding the audience's background
to help define the target audience
The use of certain visuals may
associated with different industries
be
For example, line graphs are used in the
investment profession; anatomical or
biological icons are used in health care
Many visualization methods obscure
precise values, either by aggregating them
or rendering their value as a position
against a less precise scale
How quickly the audience needs to grasp
the basic patterns present, along with the
type of data presented, will determine the
types of visualization used
Tables and dashboards are a common
visualization method
Tables are used when finding the precise
values of a limited number of observances
is crucial
Dashboards
are
used
to
quickly
communicate key metrics to management
Bar Charts and Line Charts
Trends generally have a linear component
and involve time as a measure
Histograms, or bar charts, use the length of
a bar to represent frequency or magnitude
Used to visualize data when there are few
important categories that encompass all the
data
Line charts show a frequency or a
magnitude in one dimension against a
metric in the other dimension
Instead of multiple bars, it shows a single
indicator point
These points are connected with line
segments or curved lines
Stacked Charts
A stacked chart combines the qualities of a
histogram and a line chart
Provides a visual of all points of the
difference between variables
All variables extend from their tops to the
x-axis, not just the visible portion of the
variable
Best used when the included variables do
not cross each other
Dot Plots and Flowcharts
A dot plot is a two-dimensional mapping of
observances onto a coordinate plane
One dimension represents the frequency of
observations of the other dimension
Used when there are discrete and repeated
instances of the observations
Flowcharts are best for processes that have
a beginning, middle, and end that can be
mapped
Allow learners to see potential options that
may take place during a given process
Pie Charts
Used to illustrate data points that sum to a
whole
This angular distortion can be addressed
using a doughnut chart, which is a pie chart
with the center removed
Boxplots and Scatter Plots
A boxplot displays the distribution of data,
showing the minimum, quartiles, median,
and maximum
Can show outliers and whether data is
symmetrical, widely distributed, or skewed
Scatter plots illustrate correlation by
mapping data observations in two
dimensions
Bubble Charts and Directional Charts
A bubble chart is a type of scatter plot that
uses the size of the dots to help the user
visualize magnitude or other relational
quality
Directional charts highlight key events or
milestones over time
The earliest data or event begins on the left
Pyramid Chart and Waterfall Chart
A pyramid chart shows understanding
underlying foundations or building blocks
Most helpful when the bottom layer
represents an action or a target that must
first be achieved before the next layer up
can take place
Show the relative size of the component
data sets
A waterfall chart conveys the cumulative
effect of each new or incremental piece of
information
Traditional pie charts are susceptible to
distortion
As each data point is added, its effect is
charted against the total of all data points
The proportion of obtuse-angled sections
of a pie chart may cause people to
overestimate the proportion of acuteangled sections
Communicating
Techniques
Using
Visualization
Requires more precision than just reporting
all results
Can be done by modifying traditional charts
using:
•
•
•
•
•
•
•
Figure overlaps
Relative scaling
Geographical overlays
Gradient colors
Colors that correlate for the same
data point
Sorted data
Interactive visuals
Best Practices
To effectively communicate key findings
and recommendations, there are several
considerations that can help to avoid
confusion
Minimize Visual Noise: minimize the
number of data points charted unless
attempting to emphasize volume
prevent distortion, and minimize cognitive
overload.
Avoid Absolutes: definitive language or
superlatives such as "best" or "always"
suggests a more likely interpretation
Maintain Appropriate Scale: unless there is
a compelling reason not to, scales should
start at zero and be unbroken
Avoid Bias: information stewards must
present information in an unbiased way that
does not mislead users
Use the Same Time Period: when making
comparisons, using different time periods
may lead to misleading conclusions
Faithful Representation
Data visualizations should not omit data.
The following two images are constructed
from the same data, but a trend is apparent
on the left that does not exist when all of
the data is faithfully presented on the right.
Faithful Representation
Minimize Colors: limit colors or shades to
no more than four to six to avoid distraction
Three-dimensional images complicate data
visualization
Darken for Emphasis: use darker colors for
significant details to place emphasis on the
key points
Three-dimensional images often use a
forced perspective to create the illusion of
depth
Label Sparingly: use labels when accuracy is
necessary for otherwise indistinguishable
data points
Forced perspective means that the scale
does not apply to all portions of the image
in the same way, which creates distortion
Minimize Depth: unnecessary depth may
create proportion or scale distortions or
emphasize meaningless differences
Forecasting
Avoid Over Slicing: use pie charts with only
four or five data points to avoid crowding
and confusion
Minimize Legends: avoid using legends
with too many colors as matching the
legend to the chart becomes difficult
When using visualization techniques that
mix actual data with projected, estimated,
or predicted data, clearly indicate the
difference between the data points used